News In Charts: A Second Rate Cut For India, With Scope For More

The Reserve Bank of India (RBI) lowered its benchmark rate on Wednesday from 7.75% to 7.50%, citing reduced inflationary pressures in the economy. It was the second cut this year, taking markets by surprise and pushing stocks higher. In retrospect, it is no surprise that policy was tightened through 2013 and into 2014 – a time when inflation was above target, and real rates of interest were negative. Equally, it is no surprise that the RBI has now switched to an easing bias. Inflation is already below 6% – a target that the RBI was tasked with achieving by January 2016. At the same time, the stance of policy is now unambiguously tight. The real rate of interest is close to 3%, around six percentage points higher than it had been just over a year ago. Further cuts are on the cards.

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A Budget for the corporate sector?

Indian Finance Minister Jaitley delivered his Budget speech on Saturday with the aim of attracting more inward investment. The Budget itself was undoubtedly business-friendly. Corporation tax is to be reduced from 30% to 25% over four years, while foreign institutional and foreign direct investment restrictions are to be lifted. Revenue Secretary Shaktikanta Das has countered criticism that the budget was too business focused by arguing that it will improve competitiveness, and encourage more companies to stay in India, leading to higher levels of job creation.

Officially, the Indian government is committed to running a fiscally responsible country, and planning for the ‘long haul’. We have long felt that India’s fiscal targets are overambitious, suggesting there was considerable scope for slippage. The projected budget balance has duly been revised somewhat lower, with the 3% deficit target now scheduled to be met one year later, in 2017/18. Such is the way with fiscal reforms the world over!

Considerable untapped potential in the long term

Given the right policy mix, there are of course good reasons to be optimistic about India’s growth prospects over the long term. Much like the position in China ten years ago, India has a vast number of underutilised workers in the agricultural sector. If these workers can be successfully transitioned into the secondary or tertiary sectors, where productivity is far higher, India will enjoy a sustained period of robust growth.

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A comparison of the expenditure breakdown of GDP in India with that of China can also be informative. Much of China’s growth has been driven by excessive investment, with the intention of exporting the proceeds overseas rather than consuming them domestically. Since the global recession hit in through 2008 and into 2009, China’s investment has climbed to almost 50% of its GDP. In India, by contrast, it is currently just over 30%, and in line with the average across all emerging economies. There is scope for investment to rise as a share of GDP in India, boosting productive potential, and the budget reforms may go some way towards achieving that aim.

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And reasons to be cheerful in the short term

India’s current account balance has narrowed over the past two years, largely in response to a weaker rupee, which has fallen 12% in real trade weighted terms from its peak in 2011. China attracts a weight of 16.6% in India’s trade-weighted exchange rate index, second only to the euro area. The large weight on China is likely to reflect third-country effects, with India and China competing in similar markets. The US gets the third largest weight, at 14.1%. Our view is that, later this year, China will let go of the dollar peg and allow the renminbi to depreciate significantly. But the longer the peg is maintained, the better it will be for India, particularly if the dollar continues to strengthen. Cheaper oil is also likely to act as a short-term boost, with India importing 80% of the oil that it consumes.

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Economists often construct so-called ‘misery indices’, by adding together the unemployment rate and the inflation rate. We have constructed our own. Recognising that low inflation, or more specifically outright deflation, can be at least as painful as high inflation, we have added a variant. The ‘adjusted misery index’ adds together the unemployment rate and the absolute deviation of inflation from target. India lies at the bottom of our table, one place below Russia, yet some distance from it.

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There is still some upside in Indian equity markets but expect a bumpy ride

According to the latest World Bank forecasts, and indeed those of finance minister Jaitley, India will grow rapidly through this year, overtaking China as the world’s fastest growing major economy. We concur. Given the right policy mix, India has significant growth potential in the medium-to-long term and therefore we remain overweight Indian equities. However, with equities already having experienced significant gains since Governor Rajan took office, the downside risk is slightly higher going forward, particularly if fiscal reforms continue to slip.

This research note is provided by Fathom Consulting. All of the charts below and many many more, covering a range of topics and countries on both the macroeconomy and financial markets are available in the Chartbook to Datastream users at www.datastream.com. Alternatively you can access Fathom’s Chartbook at www.fathom-consulting.com/TR.