India: Finally Out Of The Woods? Not So Soon

India: Finally Out Of The Woods? Not So Soon Friday, 01 December 2017 1 P a g e

Macro Note

Friday, 01 December 2017

Francis TanEconomistFrancis.TanTT@uobgroup.com

Global Economics & Markets ResearchEmail: GlobalEcoMktResearch@uobgroup.comURL: www.uob.com.sg/research

� India’s 2Q FY18 GDP reversed the previous 5 quarters of slowdown and expanded 6.3% y/y.

� Support came mainly from the uptick in investments. However, consumption, the largest part of GDP, remains benign. That means that both the demonetization exercise from November 2016 and the implementation of GST in July 2017 is slowing down consumer demand. Using passenger cars sales as a higher frequency proxy to gauge discretionary consumer demand, we observe a similar slowdown.

� Although inflation has picked up in the second half of 2017, it is not exhibiting the classic case of “demand-pulled” inflation as the average Indian consumer is not spending as much. Higher prices reflect the GST imposition.

� As such, it will be really too early for the RBI to embark on any rate hikes. In fact, we are expecting another 25bps rate cut in the 6 December policy meeting.

Latest 2Q FY18 Growth Supported Mostly By Sharp Improvement In InvestmentsContinuing the recent spate of economic achievements, such as the recent Moody’s upgrade1 to India’s sovereign ratings, India scored another one-up by reporting a stronger GDP expansion of 6.3% y/y in 2Q FY18 (ie: Jul-Sep 2017), reversing the previous 5 consecutive quarters of slowdown. Gross value added (GVA) data shows the same improving trend as it expanded 6.1% y/y, from 5.6% y/y in 1Q FY18.

The change in the direction of India’s economic growth is certainly welcomed as the country had been negatively impacted by the November 2016 demonetisation exercise, which reduced the growth in consumer demand following the ban on Rs500 and Rs1,000 currency notes. But, does this mean that the woes created from the demonetisation exercise are over? As much as we want to believe that it is over, it may not be.

1 Read our report on Moody’s upgrade here: http://www.uobgroup.com/assets/pdfs/research/MN_171120A.pdf”

EXHIBIT 1: India’s GDP Breakdown By Expenditure Components

Source: Macrobond, UOB Global Economics & Markets Research

India: Finally Out Of The Woods? Not So Soon Friday, 01 December 2017 2 P a g e

Looking at the GDP by expenditure, India’s private consumption seems not out of the woods yet. Domestic consumption is the strongest driver of economic growth in India, with a contribution of 54% to overall GDP growth in the latest quarter. EXHIBIT 1 shows the breakdown of the % point contribution to overall GDP growth.

While it may not be too evident on the specific driver for the 6.3% y/y GDP growth in the latest quarter, EXHIBIT 2 shows that the uptick in overall GDP growth was due to the robust improvement in investment (contributing to 29% of GDP growth), while consumption continued to slow.

In a news article carried by India Today2 (30 November 2017), it quoted Union Minister Arun Jaitley saying right after the release of the GDP numbers “Demonetisation and GST’s impact is behind us and hopefully in coming quarters, we can look for an upwards trajectory.”

From our analysis, we do not think that the negative impact of demonetisation and 1 July 2017 GST implementation is over yet as EXHIBIT 2 clearly shows that consumption demand remains weak, and fell further to an expansion of 6.5% y/y, from 6.7% y/y in 1Q FY18.

Consumption is the largest portion of the economy and we need to see significant pickup in it before we agree with Minister Jaitley. Moreover, investment is generally volatile3. A quarter of strong pickup may not be as sticky as a same pickup in consumption.

2 http://indiatoday.intoday.in/story/gdp-growth-bjp-congress-arun-jaitley-chidambaram-mamata-banerjee/1/1100586.html3 The standard deviation of consumption growth was 2.65%, while that of investment was 3.01% for the entire length of time series.

EXHIBIT 2: Investment Growth Led Overall 2Q FY18 GDP Growth, While Consumption Remains Benign

Source: Macrobond, UOB Global Economics & Markets Research

EXHIBIT 3: Growth Rate Of India’s Passenger Cars Sales Is Still Slowing

Source: Macrobond, UOB Global Economics & Markets ResearchNote: Shaded Region denotes Recession

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As a gauge of the state of consumption in India, we like to turn to a higher frequency indicator – passenger car sales. As the year-on-year data is quite volatile, we smoothed the data series over a rolling 12-month period and it shows continued weakness in sales since a recent peak in May 2017 (EXHIBIT 3).

By analyzing the expenditure components of India’s GDP, we certainly do not think that the near term economic prospects are out of the woods yet, although the improvement in investment is very encouraging indeed. Overall, India’s economy is still performing below its potential level in 2Q FY18, a trend for the past 5 consecutive quarters (EXHIBIT 4). That said, the negative output gap is closing up.

Strong Manufacturing Recovery Boosted Overall GDP GrowthIn terms of industry, the manufacturing sector (18% of GVA) expanded by 7% y/y in 2Q FY18, a strong jump from the 1.2% y/y growth in the previous quarter, and probably explaining the quick increase in investments. However, the pace of expansion pales in comparison to the 7.7% y/y seen in the 2Q FY17.

Of note, the Trade, Hotels, Transport, Communication & Broadcasting Services (19% of GVA) performed well and gained 9.9% y/y, although it was a tick lower than 11.1% y/y in the previous quarter.

The financial services sector (the economy’s largest sector at 26% of GVA) gained 5.7% y/y, down from 6.4% y/y a quarter ago. Meanwhile, the construction sector (7.7% of GVA) expanded 2.6% y/y, from 2.0% y/y in 1Q FY18. EXHIBIT 5 shows the trend in the selected industries’ GVA.

EXHIBIT 4: India Still Operating Below Potential, But Certainly Sees Improvement

Source: Macrobond, UOB Global Economics & Markets Research

EXHIBIT 5: Performance Of India’s Three Largest Sectors

Source: Macrobond, UOB Global Economics & Markets ResearchNote: Shaded Region denotes Recession

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Uptick In Inflation Does Not Mean RBI Should Be Too Hawkish YetIndia’s inflation had been trending higher in the second half of the year and that had prompted many to fear that the Reserve Bank of India (RBI) could start on an interest rate hiking path.

Overall inflation (urban and rural combined) rose to 3.6% y/y in October 2017, from a recent low of 1.5% y/y in June 2017. Food prices followed the same trend and climbed to 1.9% y/y in October, from a recent low of -2.1% y/y in June.

In the study of economics, it is important to determine the source of inflation – demand-pulled or cost-pushed. The former is caused by an economic expansion and the driving up of prices due to stronger consumer demand. We note from the above that this is still not true in India’s situation today.

The latter is due to idiosyncratic, supply-side issues such as an oil price shock, or in this case, the implementation of the GST.

Moreover, compared to historic inflation average of 6.6% (EXHIBIT 6), the current inflation levels are still low.

We think that with prices still considerably benign, and the economy just starting to reverse the past five quarters of declining growth trend, it will be a tad too early for the RBI to even think about hiking interest rates.

In fact, we are still expecting the RBI to cut another 25bps in the upcoming 6 December 2017 policy meeting (the last meeting for 2017) to 5.75%4. The continuous accommodative monetary policy will help to cushion the negative impact of a tightening fiscal policy (via the GST implementation from July 2017).

Already, the INR has climbed 5.4% against the USD so far this year. A stronger INR will not bode well for the tradeables sector of the economy (especially for manufacturing and business process outsourcing sectors) into 2018. A hawkish RBI may risk pushing the INR even stronger and cause more headwinds for the mentioned sectors.

4 The most recent 25bps rate cut was in August.

EXHIBIT 6: Although Inflation Moving Higher, It Is Not Because Demand Is Strong And Is Still Low By Historic Standards

Source: Macrobond, UOB Global Economics & Markets Research