Thursday, February 19, 2015

India's economic resurgence

It has been a fascinating 18 months for the Indian economy.  During the taper tantrums of 2013 India was anointed one of the so called “fragile five”.  That gave the depreciation in the real effective exchange rate a further nudge lower.  Since then the current account deficit has narrowed considerably from -4.7% of GDP in 2013 to -1.3% in September 2014, reducing India’s external vulnerabilities.

2014 was notable for the decline in inflation and the election of the business-friendly Narendra Modi as Prime Minister.  Modi was previously the Chief Minister of the state of Gujarat – a state that has recently been outpacing growth in the national economy.  Modi was elected on a platform of doing for India what he had done for Gujarat.

Inflation halved from over 10% at the end of 2013 to 5.1% in January 2015 (a new rebased series).  The adoption of a new inflation targeting regime and supply side economic reforms has assisted the disinflation although it’s important not to overstate their importance, at least not in the short term – it takes time for structural reform to have an impact. 

The more recent decline in inflation has been due to lower commodity prices, particularly oil.  India is a major beneficiary of lower oil prices.  The Reserve Bank of India (RBI) has responded to the improved inflation environment by cutting interest rates with further rate cuts likely over the next few months..

In 2015 revisions to historical GDP data means the growth rate in the economy has been significantly higher than previously estimated.  Annual growth that was initially reported at 5.3% for the year to September 2014 has revised up to 7.8% in the new series.  Growth came in at 7.5% for the year to December.  I thought it would be 2016 before we saw India outpacing China when it was already there!

I’ve been upbeat about the prospects for the Indian economy recently, expecting that growth would accelerate this year.  Growth appears likely to continue to benefit from the clearing of roadblocks to major infrastructure investment projects, easing in monetary conditions and continued supply-side reforms including tax, land acquisition and the in the finance sector.  So I’m sticking to the story that growth will accelerate this year with 8.0% likely in calendar 2015.

Longer-term it is the labour market that is India’s greatest opportunity and the greatest threat to its long-held ambitions of outpacing China growth on a sustained basis.

Unlike China, India’s working age population (WAP) is expected to continue to expanding.  The United Nations is projecting India’s WAP to increase at around 1% per annum until 2030 while China’s will show a small decline over the same period.  If you think about growth being the sum of growth in the labour force and growth in productivity, India appears to have a head start.  But India’s labour market is highly inflexible leading to high reliance on informal labour.  Efforts to lift the participation rate, especially for women, will be essential if the advantage of a growing WAP is to count for anything.

On the productivity side of the equation strong investment growth is necessary.  In that respect efforts to unblock infrastructure projects are welcome but further work is required on attracting higher levels of Foreign Direct Investment along with measures to boost household savings to help keep the current account deficit in check.
Graph: saving and investment

So there is good reason to remain optimistic about the outlook for India, but that requires the Modi government to deepen the reform efforts.  If they achieve that successfully I see no reason why India shouldn’t enjoy a sustained period of growth in the 7-8% range.  

In terms of India’s imbalances I expect we will see further improvement in the current account deficit while improvement in the fiscal deficit will be harder work.  That will continue to require tax reform and strong expenditure control although higher growth will help.