India - growth revival more certain

This week saw India’s Central Bank hike interest rates for the first time in four years; a move that caught most (but not all) economists by surprise.

The reaction from the Indian financial markets after the rise did however indicate that the market had already begun to price this move in as equities and the Indian rupee strengthened. While we consider this move to be somewhat premature in relation to India’s underlying macro fundamentals, we do appreciate that international factors did play a large part in this decision. More importantly we regard the action from the Reserve Bank of India (RBI) as confirmation that growth is indeed recovering and becoming more entrenched for the first time in a number of years.

The RBI’s Monetary Policy Committee unanimously agreed to increase the repo rate by 25bps to 6.25%, but kept its stance/tone on the economy neutral and not hawkish as some expected. This was reflected in its retention of fiscal year (FY) 2019 GDP growth target of 7.4% with risks evenly balanced. The inflation forecast for the second half of FY 2019 was however raised to 4.7% from 4.4% and this is the area that concerns the RBI most.

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There are worries that the recent rise in core inflation and energy prices, plus concerns over potential food price increases will impact households’ inflation expectations if left unchecked. In addition global factors have led to the Indian rupee depreciating nearly 6% (year to end May) versus the US dollar which has pushed up the price of imported goods/services. Currency depreciation has impacted other emerging markets resulting in various central banks tightening rates as a response, so in that context the RBI didn’t want the perception that it had fallen behind the curve.

As a result the market and economists are likely to be even more fixated on monthly economic data in their attempts to predict central bank moves. Taking these factors into account we would view that the RBI has front loaded this rate rise and now anticipate that interest rates will be left at current levels for a prolonged period of time assuming that the monsoon (rains) are normal. It is a shame that the RBI didn’t delay this policy action a few more months as the statistical base effects that have had a significant impact on both growth and inflation data over the last few quarters wash away. This was a result from the disruptions caused over the last couple years from demonetisation and the implementation of the pan-India Goods and Services Tax, which have acted to statistically increase inflation and growth numbers. The impact of the base effect on inflation should begin to change from July which should push inflation lower, hence our belief that the RBI is being premature in raising interest rates.

There are worries that the recent rise in core inflation and energy prices, plus concerns over potential food price increases will impact households’ inflation expectations if left unchecked.

On the other hand growth is certainly becoming more evident across India. Not only have we just completed the latest quarterly earnings season where corporate sales growth was better than expected, but at the end of May India reported first quarter GDP growth which accelerated to 7.7% in the 3 months ended 31st March, the fastest in 7 quarters. Growth surprised on the upside led by government spending and investment with agriculture (+4.5%), manufacturing (+9.1%) and construction activities (+11.5%) being particularly strong. We expect this growth to moderate slightly in the period ahead as the positive base effects start to wear off as well as a fall in government led investment activity as we near the election next year.

Whilst growth has certainly improved, and with the RBI somewhat more preoccupied by external factors we should not lose sight of the underlying improvements/reforms that have been made over the last few years that will improve the quality and resilience of the cycle in India. Reforms on the macro policy front include the introduction of an inflation targeting regime. Reforms on the governance front include the introduction of an entirely electronic, paperless GST system, a new bankruptcy code, a new real estate act and of course the ongoing push to formalise the economy through the use of innovative technology interfaces. There has also been a massive increase in physical infrastructure projects. All the changes/reforms ultimately give us increased confidence in the India growth story going forward, and hence the outlook for Indian corporates remains an exciting one.