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Domestic developments are back to the fore

There is a temporary reprieve from global risk-off catalysts (oil and dollar), but developments are still fluid as we head into 2019, writes Radhika Rao, DBS’ Economist for India, Thailand & Eurozone.

For India, domestic developments are back to the fore. We address five questions facing the economy, with implications for 2019, Rao writes in the bank’s in-house reports on 14 Dec 2018.

What gains will accrue from lower oil prices?

Prices of the Indian crude oil basket peaked in early-October and has since corrected by 25%. From US$80 per barrel average in October, Brent is tracking US$60pb in December. This partly reflects buoyant production in the US and temporary waivers on oil purchases from Iran.

For India’s external balances, lower oil prices imply some reprieve on the FY19 current account and balance of payments position. High sensitivity of oil prices to India’s current account balances i.e. for every 10% rise in oil prices, the CAD stands to rise by 0.4% of GDP, make it an important external factor to monitor.

If oil prices average US$75pb this year, the current account deficit is likely to stand at -2.5% of GDP, better than our forecast of -2.7%. The balance of payments deficit will narrow to US$15-20 billion, vs ~US$25 billion earlier. For further relief to the BOP, a deeper correction in oil prices requires to be accompanied by better risk-appetite (i.e. reversal in capital outflows).

Lower oil is a clear positive for the Indian economy, even though the domestic fuel tax structure only allows partial pass-through of the sharp correction in international benchmarks. Inflation is unlikely to be swayed significantly by the recent pullback in oil prices, as food prices have been a bigger driver of late, as we discuss below.

If anything, lower oil adds to the disinflationary forces at this juncture. Growth momentum is expected to soften on base effects, lagged impact of tighter rate conditions and weaker rural demand, with low oil marginally improving the room for discretionary spending and lower input prices.

Inflation: lower for longer?

Sustained moderation in India’s inflation in the past four years continues into FY19. The disinflationary spell in FY19 has been dramatic, as CPI inflation fell from 4.9% YoY in April-May 2018 to 2.3% in November.

Disinflationary pressures from the food segment (-2.6% YoY vs Oct’s -0.9%) overwhelmed firmer service sector inflation. The latter is also showing signs of softening, aided by cuts in domestic fuel prices, negative base effects and waning impact of administrative changes (housing rent allowance etc.)

Food disinflation stems from weaker cues from global farm commodities, along with domestic over-supply and inefficient procurement strategy for crops under the Minimum Support Prices (MSP). Most food categories are showing low inflation, vegetables, pulses and sugar have been on a steady declining streak.

Reasons behind this slump vary from seasonal fluctuations, higher imports and export restrictions in some cases have increased domestic supply.

Kharif crop MSPs were announced to support farm prices and in turn incomes, but procurement challenges continue to see ex-farm prices at well below listed MSP rates.

Add to this, data breakdown also points to subdued rural demand. Rural inflation has declined at a faster than urban, with its core measure also off highs in recent months. Urban inflation has also eased but the pullback is more modest; from average 6.2% YoY in January-October to 5.8% in November. Secondly, the rural terms of trade i.e. food vs non-inflation changes have also weakened, boding poorly for demand conditions.

With supply-demand dynamics pointing to a soft phase for food inflation (50% of the basket), this will continue to offset intermittent bouts of imported pressures (oil and rupee). The evolving inflation trajectory for FY19 suggests that headline inflation might stay below 3.5-3.8% until March 2019, posing downside risks to our full-year forecast of 4.0%.

While 2-3% inflation levels will be fleeting, the trajectory is likely to stay relatively benign and near target next year. FY20 inflation is seen at 4.2%, factoring in a modest increase in food inflation on pro-farm support measures, steady commodity prices and negative base effects from this year.

What does the change in guard in the Reserve Bank of India mean for policy?

The government appointed a career bureaucrat Shaktikanta Das as the new Reserve Bank of India Governor on 11 December 2018, a day after his predecessor Urjit Patel stepped down. A former Economic Affairs Secretary, he was a member of the Fifteenth Finance Commission, and has also worked under Department of Expenditure, amongst other civil service roles.

Incoming Governor’s immediate tasks include addressing concerns of the domestic banking sector which faces tight resolution deadlines under the revised stressed asset framework announced back in February.

At the 5 December policy review, the policy panel under former Governor Patel had already revised down inflation forecasts for rest of FY19 and FY20, laying the ground for a possible shift in stance to neutral at the next policy review.

The new Governor’s remarks in the run-up to February’s review will be watched closely, with inflation outcomes in the interim to hover around ~2.0-2.8%, well below the 4% target.

If inflation doesn’t deviate from the RBI’s latest forecast (November CPI is already on the lower end of the 2.7-3.2% forecast) and FY19 fiscal deficit is kept close to target of -3.3% of GDP (DBS f: -3.4-3.5%) at 1 February 2019 budget, a reversal in the policy stance to neutral is on the cards at the February rate review.

The real rates cushion is more than ample. Growth projections for FY19 are expected to be lowered from 7.4% (DBS f: 7.1%) and FY20. Rate cut expectations are rising for the April meeting, which if exercised, might be in for a shallow cycle as negative base effects from FY19 is likely to perk FY20 inflation back above 4%, set against an uncertain global backdrop.

How real are fiscal slippage risks?

The April-October 2018 central government fiscal deficit is already higher than the FY19 target of -3.3% of GDP. This is more due to a slower pick-up in revenues, whilst expenditure was front-loaded. There is reason to expect total tax revenues to fall short of targets, despite 2H being a seasonally strong period.

Net direct tax collections have reached the half way mark, with four months left this FY. Add to this, the centre’s monthly GST revenues are Rs.50-70bn below the required run-rate to meet the annual target.

Divestment efforts need to be kickstarted, with year-to-date collections still at a fifth of the target of Rs.800bn. For rest of the year, rather than IPOs, plans are to offload minority stake sales, conduct share buybacks and ETFs by end-year, alongside a possible merger of power sector financing firms.

The deterioration in the fiscal math is not completely out of sync with the past years, with a course correction usually likely in the last few months of the year, when revenues catch-up and expenditure is curtailed.

For FY19, despite a likely revenue shortfall, a sharp miss to the FY19 deficit target of -3.3% is unlikely. Slippage, if any, will be limited to -3.5% of GDP, in line with past two years. Expenditure compression is on the cards, helped also by the freeze that routinely takes effect in the final quarter of the year.

For FY20, the authorities might stick with the -3.1% target as recommended glide path, assuming greater traction in GST revenues due to a wider tax base and improved compliance, and steady commodity prices.

At a consolidated level, state fiscal deficits have been higher than the 3% of GDP FRBM (Fiscal Responsibility and Budget Management) threshold for the past three years and might extend into FY19. This, in turn, will keep India’s general government deficit levels elevated at 6.5% of GDP in FY19 and 6.2% in FY20.

What does the growth trajectory hold?

Our in-house GDP Nowcast model, which uses statistically key data (latest available) to constantly update our estimate of economic activity and an autoregressive forecasting framework to build a forward-looking trend, signals a slowdown in the growth momentum.

India’s 3Q18 (second quarter of FY19) growth slowed to 7.1% YoY, a step down from 8.2% in 2Q. On the supply-end, Gross Value Added (GVA) growth stood at 6.9% from 8% in 2Q.

Base effects continue to be adverse at least until mid-2019, implying growth will revert to mean in the coming quarters. To add, cyclical slowdown will also extend to 2HFY19 owing to limited fiscal room, tight financial conditions, and weak farm incomes.

Easing oil prices will reduce the drag from sub-par trade, but tougher slower global growth and a firm real rupee might constrain exports at the margin.

While the early impact of the trade dispute will be visible in the regional trade performance come early 2019, the relatively smaller dependency of India’s growth on the external sector is expected to shield the economy from any direct impact of a deterioration in the US-China trade relations.

From 7.7% in 1HFY19 (i.e April to September), we look for India’s 2H real GDP growth to average 6.6%, arriving at our full-year forecast of 7.1%.

As demonetisation and GST-driven base effects fade, growth is likely to slip into a softer yet stable growth trajectory. We look for FY20 growth at 7.4% YoY.

The political environment will also be watched closely after the ruling party had a setback at the recent state elections. History suggests that state polls provide a foretaste, but not conclusive direction on the general elections.

For the markets, political uncertainty poses a short-term hurdle, offsetting some of the positive impact from the sharp drop in oil prices and easing rate volatility. In the long-term, corporate earnings will still be the predominant driver for the broader market direction.

The global landscape remains a key wildcard. Factoring in our current expectations of a US Fed tightening cycle to continue into 2019, with an eye on the end of the 90-day waivers on oil exports from Iran, by 1Q19, the direction of oil and USD/rates will be watched closely.