Friday, June 1, 2012

India’s structural challenge and China’s balancing act

This week we saw critical GDP data out of India and PMI data out of China.  Both highlight challenges for the respective economies.  In India, both monetary and fiscal policies have constraints, meaning structural change will be important in the recovery.  In China, the authorities have more room to move, but need to balance the desire for a soft landing with not giving up the hard won gains on inflation.
India's GDP growth rate slumped to a disappointing 5.3% in the year to March 2012.  The market consensus was expecting growth to remain unchanged at December 2011's 6.1%.
The problem in India is that authorities are somewhat constrained.  Failure to contain expenditure (particularly subsidies) saw the March 2012 year fiscal deficit come in at 5.9% of GDP, missing the official target of 4.6%. 

Monetary policy is constrained by an inflation rate that is proving to be “sticky” at around 7%.  That is in some part due to the 20% depreciation in the Indian rupee over the last 12-months.  While that will no doubt prove of some assistance to the tradeable sector, it limits scope for further interest rate reductions.  That’s a problem given the extent to which private sector investment has come off the boil in recent months.  The Reserve Bank of India cut interest rates by 50bps in April.

The high budget deficit is coinciding with the worst current account balance (-3.6% of GDP) in over 2 decades.  In that respect, India is facing similar challenges to some developed economies where fiscal consolidation is an important part of the pathway to higher sustainable growth. 

The best thing India could do right now is articulate a credible strategy to reduce government spending which would provide further scope for interest rates to fall and support a recovery in private sector investment.  Stronger investment will also require policy (particularly regulatory) reform.  The current government does not have a strong reform track-record after back-tracking on planned retail sector reforms last year.  In short we are anticipating neither a strong nor swift recovery in growth.  

In China the official PMI fell from 53.3 in April to 50.4 in May.  The continued strength in this index has been at odds with the unofficial HSBC index which has been languishing under the critical 50 level for several months.  Part of that difference is explained by the coverage of the two indices with the official index focussing on the larger SOE’s while the HSBC index captures the SME market.
As discussed in our last China post, we think China has further to slow with the June quarter of this year now likely to be the low point in the current cycle.  We think GDP will fall from an annual 8.1% in March 2012 to under 8% in the June year.  This dip down in the May PMI, along with weaker than expected April month partial activity data, supports that view.

The Chinese authorities are faced with a challenging balancing act:  generating a soft-landing for activity without giving up the hard won gains on inflation.  Inflation looks well behaved at the moment and we expect headline inflation to cool further over the next few months.  Indeed the prices index in today’s PMI data fell 10 points to 44.8.

We continue to expect easing of both monetary and fiscal policy to support a tick-up in growth in the second half of the year.  The authorities have already cut bank required reserve ratios several times and we expect it will be cut further.  We also expect interest rates to be reduced, but probably not until the authorities see inflation move lower.

In the last couple of weeks authorities have also taken steps to boost infrastructure spending, although that requires another balancing act.  Fiscal policy was used aggressively in the GFC recession: we don’t expect a repeat of that approach this time, nor do we think it will be needed.  The Chinese leadership committed to “better quality growth” in its 12th 5-year plan and aggressive easing in fiscal policy does not fit well with that commitment. 

However fiscal measures to assist the rebalancing in China growth towards consumption, such as the recent announcement of RMB 36 billion in subsidies for household purchases of energy saving appliances and automobiles, will provide a useful boost to domestic demand.  We also like moves towards allowing the private sector to invest in some state dominated industries such as railways.

We continue to expect China GDP growth of around 8.5% for the calendar year.