India is hit hard by the COVID-19 pandemic; infections continue to spread rapidly, weighing on the economy’s recovery.
India’s weak public finances prevent impactful fiscal stimulus.
Elevated inflation complicates the Reserve Bank of India’s monetary easing efforts in the near-term; inflationary pressures are expected to be transitory, allowing for additional interest rate cuts by year-end.
ECONOMIC GROWTH OUTLOOK
India's economic outlook remains weak as COVID-19 infections continue to spread rapidly (chart 1). India has become the third-hardest hit country globally, after the US and Brazil. To deal with the outbreak, India implemented a nationwide lockdown from March 25 to May 31 that caused both rural and urban demand to collapse. A gradual re-opening that started in June brought about a pickup in activity (charts 2 and 3); now, however, some signs are emerging that the revival may be levelling off due to reintroduction of movement restrictions in parts of the country. It is clear that the virus outbreak is nowhere near to being over; therefore, India’s economic activity will likely remain muted by historical standards for months to come.
The curtailment of movement, the closure of most businesses combined with a sharp deterioration in consumer and business confidence (charts 2 and 3) have resulted in a substantial reduction in consumer spending and capital investment. Similarly, India’s external sector has suffered as non-essential services and manufacturing were halted. We expect the economy to recover—albeit in a bumpy fashion—through the rest of the year, led by the rural economy as the agricultural sector is benefiting from a favourable southwest monsoon.
Public outlays will underpin activity to some extent, yet India’s weak public finances prevent truly impactful fiscal stimulus measures. According to International Monetary Fund data, India’s general government deficit was 7.4% of GDP in 2019, substantially larger than the budget shortfalls of its emerging market peers. The central government deficit for the fiscal year 2019–20 (April–March) was 4.6% of GDP, exceeding the revised target of 3.8%. In March, the government, led by Prime Minister Narendra Modi, announced a fiscal stimulus package worth 0.8% of GDP to cushion the economic impact of the COVID-19 outbreak. This was followed by another round of stimulus in May totalling INR 20 trillion, equivalent to 10% of GDP. Nevertheless, a large part of the package consists of government loan guarantees, credit extensions and the Reserve Bank of India’s (RBI) monetary measures; only about 1% of GDP represents direct public spending. Given India’s weak outlook, we expect the government to unveil further—although modest—measures in the near future, such as reform initiatives and infrastructure projects to underpin the economy’s growth momentum.
India’s real GDP growth trajectory will be highly dependent on the persistence of the virus outbreak; as the situation has become more challenging than we earlier estimated, we recently made a significant downward revision to our growth forecasts for India. We now expect real GDP to contract by 5.2% in 2020, vs. a decline of 2.0% y/y in our June forecast update. In 2021, we project a strong rebound of 8.3% y/y on the back of pent-up demand and base effects.
India’s medium-term growth outlook will be underpinned by favourable demographics, competitive labour costs, and the implementation of structural reforms in recent years. Nevertheless, further reform progress is needed for the economy to return to a robust growth trajectory in a sustainable fashion. We also note that potentially persisting weakness in India’s banking system hinders the country’s medium- and long-term growth prospects.
INFLATION, MONETARY POLICY, AND RUPEE OUTLOOK
Elevated inflation is complicating the RBI’s policymaking. At the August 4–6 Monetary Policy Committee (MPC) meeting, the central bank opted to leave the benchmark repo rate unchanged at 4.0% despite the challenging economic backdrop. The policy rate has been reduced by 115 basis points so far this year, following cuts of 135 bps over the course of 2019 (chart 4). The RBI maintained an accommodative policy stance and pointed out that it has policy space left for further stimulus, implying that additional interest rate cuts are in sight once inflationary pressures ease.
The RBI’s monetary policymakers have pointed out that the Indian economy is experiencing “unprecedented stress” and that the outlook is characterized by “extreme uncertainty”. Meanwhile, they have also highlighted that the RBI’s primary mandate is to achieve the medium-term inflation target of 2–6% y/y. India’s headline inflation has risen above the target, reaching 6.9% y/y in July, vs. 5.8% in March (chart 4). While the pickup mostly reflects higher food prices and will likely be a temporary phenomenon, the policymakers wish to get more clarity on inflationary dynamics. Indeed, the National Statistical Office was not able provide inflation rates for April and May due to difficulties in data collection caused by the nation-wide COVID-19 lockdown. While estimates for the missing months have since been unveiled for business continuity purposes, the MPC has highlighted that the inflation outlook is surrounded by significant uncertainty. The policymakers will closely monitor two key inflationary developments over the coming months: 1) elevated food prices reflecting floods in eastern India and lockdown-related disruptions and 2) cost-push pressures caused by high taxes on petroleum products and hikes in telecom charges, for instance.
We expect India’s current inflationary pressures to prove transitory; headline inflation will likely ease significantly in the final months of 2020, approaching the target mid-point of 4% y/y by the end of the year. Given the challenging economic backdrop and India’s limited fiscal stimulus space due to weak public finances, we believe that more accommodative monetary policy will be needed to underpin the economy’s recovery. Accordingly, we assess that the RBI will take the benchmark repo rate to 3.50% by the end of 2020.
The Indian rupee (INR) outlook is clouded by country-specific factors, such as India’s frail economic growth outlook, elevated inflation and fragile government finances (chart 5). Meanwhile, the currency is also influenced by the mood and risk appetite of international investors. Against such a backdrop, the RBI continues to smooth excessive rupee exchange rate swings in both directions. The INR is currently trading in a range of 74.5–75.5 per US dollar (USD); we expect USDINR to hover around 74.0 in Q3 and Q4, assisted by broad USD weakness.
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