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Growth Likely To Post a Recovery By FY11

14 December, 2009
We expect :
 
Upside surprises in industry to offset a weak summer crop, likely resulting in FY10 GDP growth of 6.2%YoY and a recovery to 7.8%YoY in FY11.
 
Key concerns to be inflationary pressures, if food and fuel prices continue to rise; and continued dollar inflows. This could likely make management of flows a challenge. On a positive note, we think clarity on divestments would help alleviate the fiscal situation.
 
While loan growth remains anaemic, better-than-expected IIP data and rising WPI will likely prompt tightening by early 2010. On the rupee, our view remains that of a structural appreciation in the currency.
 
WHAT’S HAPPENED SO FAR
 
While it is early days yet, agriculture has surprised on the upside and as mentioned in our 2QFY10 GDP update could result in ~50bps upside to our full year estimate of 6.2%.
 
Growth likely to post a recovery by FY11
 
Lower agriculture output will likely be offset by stronger industrial production. With the 2009 Monsoons being the worst in decades and the year being declared as an all-India drought year, overall agriculture growth is likely to come in at -4%. However, unlike past droughts, the impact should be muted due to (1) ongoing stimulus measures, namely the national rural employment
guarantee act, the farm waiver and the pay revision; and (2) the impact of new hydro-carbon discoveries coming on stream.
 
GDP will likely moderate in FY10, before posting a recovery in FY11. Despite the momentum in industry growth, overall GDP in FY10 is likely to come in at 6.2% vs 6.7% in the previous year. Going forward, with the improvement in the macro-environment, we expect the investment cycle to regain momentum thereby resulting in FY11 GDP growth coming in at 7.8%.
 
Fiscal – some light at the end of the tunnel
Deficits are back at double-digit levels. The United Progressive Alliance’s (UPA’s) first budget in its new term was a disappointment, with the FY10 fiscal and revenue deficits pegged at 6.8% and 4.8% of GDP respectively. With expenditures crossing the Rs10trn mark, the headline deficit numbers are now back at levels last seen in 1991. Adding on the state fiscal deficits and offbalance sheet items, the deficit is now close to double-digit levels.
 
However, post this fiscal year, we see reasons to be hopeful. On the revenue side key factors are (1) better growth, which would result in revenue buoyancy, (2) divestment proceeds, (3) a roll-back in some fiscal stimulus measures such as lower excise duties, and (4) the introduction of a Goods and Service Tax (GST). On the expenditure side, the leeway here appears to be in (1) the farm waiver, as most payments are likely to be done by FY10, and (2) arrears of the
pay commission, which are likely to be paid out by FY10. An added bonus would be (3) phase-out of some subsidies, possibly in the fertiliser & oil space.
 
External Sector – management of FX flows a key focus area
 
Current Account will likely turn to a surplus in FY11. While higher oil prices took their toll on the current account resulting in the deficit widening to 2.6% of GDP in FY09, new hydrocarbon discoveries coupled with lower prices are likely to result in the CAD narrowing to 0.8% of GDP in FY10. We expect to see current account surpluses from FY11 onwards, although an uptrend in
invisibles could positively impact the numbers in FY10 as well.
 
Managing capital flows will be a key challenge. Dollar weakness and relatively higher domestic growth coupled with monetary tightening sets the environment for a continuation of capital inflows. We believe that similar to FY08, the RBI could once again be caught in the trap of the ‘impossible trinity’. In response to rising flows, we expect (1) the initial goal would be to re-build reserves that
were run down during FY09, (2) some INR appreciation to offset inflationary pressures, and (3) although we do not expect that India will impose ‘punitive controls’, one could see a reversal of some measures taken last year. This could include tightening ECB and banking capital norms, reducing interest rates on NRI Deposits, and encouraging capital outflows.
 
Monetary tightening to begin by early 2010
While current trends are still benign, inflationary pressures will likely mount in 2010. We expect the headline WPI to rise to 6% levels by Mar10, from 1.3% currently. However, two key risks are (1) Agriculture — a poor crop could add to pressures if prompt measures are not taken to release the buffer stock of food grains and import items. (2) Rising crude prices: given that transport and cooking fuel prices are administered, the extent of the impact on inflation
would depend largely on the extent to which prices are raised. This would be a balancing act between raising fuel prices and inflation, vs keeping them constant and imposing fiscal strain/under-recoveries for oil companies.
 
We expect rates to be tightened by 125bps over the year. While loan growth remains anaemic, better-than-expected IIP data and rising WPI will likely prompt tightening by early 2010. We maintain our call of 125bps tightening in 2010 as inflation is primarily supply-side driven and excess tightening would have implications for the rupee.
 
Financial markets
Yields could breach 8% levels if inflation surprises. While our base case is that of yields rising to 7.75%-8% levels, inflation breaching 8% could result in more aggressive monetary tightening and yields edging to 8.5% levels. A few points that may prevent yields from spiking are: (1) the market is pricing in a tighter liquidity environment next year. (2) Although the cushion available via unwinding the MSS is no longer available (outstanding MSS at Rs188bn), this could change depending on capital inflows. (3) Lastly, the RBI has enough levers available to make sure that there is enough captive demand for bonds.
 
Rupee likely to continue along appreciation path. With the underlying theme of dollar weakness and relatively strong domestic growth, we see the INR trending to Rs44/US$ and Rs41/US$ in Mar10 and Mar11 respectively. However, similar to other EM ( Emerging Market ) assets, there would be a tussle between ‘risk on’ and ‘risk off’.

 


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Growth Likely To Post a Recovery By FY11

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