Indian Economy – Flies into turbulent weather

by. Manish Marwah

Recently, the Central Statistical Organization (CSO) of India pegged GDP growth for FY09 at 7.1 per cent, which would be the slowest in the last six years. Still, it looks an impressive number particularly in a year when global growth has collapsed and largest economies of the world like USA, Europe and Japan have already started experiencing a recessionary trend. For calendar year 2009, IMF has projected global GDP growth at 0.5% whereas India’s GDP growth is projected at 5.1% - still a remarkable growth when world is likely to be standstill. Resilience - the word aptly quoted by many to describe the behavior of Indian Economy. We have tried to stress test Indian Economy’s resilience under three different scenarios – Optimist, Base case and worst case.
First look at the composition of India’s GDP which is expected to reach USD 1.13 trillion mark at current price and USD 760 billion at constant price in FY09:
GDP estimates by expenditure for year 2008-09 at constant (1999-2000) price:

Source: CSO advance estimates
Domestic consumption - Things are OK On face of it, India’s economy seems to be resilient. Domestic consumption (government + private) comprising more than 67% of GDP is indeed resilient thanks to pay revisions of government employees, strong rural income growth, moderating but still strong urban incomes, high savings rate and government’s contra-cyclical efforts (to keep growth going). These components are unlikely to falter or at worst will moderate and still contribute the most to FY10 GDP growth.
Private final consumption expenditure (PFCE) - Though private industrial & service sector wage growth is moderating or in some cases contracting due to salary cuts and layoffs; rural income has grown strongly in recent years thanks to higher agro commodity prices while wages of government and public sector employees has been revised last year or is under revision. This is coupled with savings of past years will likely to keep PFCE resilient.


Government final consumption expenditure (GFCE) - Though in its interim budget, government has estimated only a modest 5.8% yoy increase in its total expenditure for FY10 (2.7% yoy increase if we exclude interest payment); new government, post election in April 2009, is likely to increase budgetary expenditure by 0.5-1% of GDP.
However macroeconomic realities of current and imminent fiscal slippages resulting (from government expenditure beyond targets) are hard to ignore. Combined fiscal deficit (Central + State + off-budget items) is likely to reach 10-11% of GDP in FY09 and likely to remain high at 8-9% of GDP in FY10. In FY10, further fiscal slippages are likely because as per budgetary estimates, corporate tax revenue is likely to grow at 10% whereas reality is that most of the experts put SENSEX companies earning growth close to zero for FY10. Government’s corporate and income tax revenue target seems to be overestimated.
Central government borrowing resulting from fiscal deficit has increased to Rs 2.6 trillion in FY09 from original budgeted Rs 1 trillion. In FY10, it is pegged at Rs 3.1 trillion. This kind of borrowings is likely to keep pressure on interest rate and can crowd out private investment, making it more difficult for Indian corporates to raise fund at reasonable rates in otherwise turbulent credit market.



Higher than expected fiscal stimulus by government @ 2% of GDP
Based on recent government estimates + new government fiscal stimulus of 1% GDP
Less than expected tax collections limiting governments ability to spend

Gross Capital Formation - A significant slowdown ahead Gross Capital Formation (GCF) consists of Gross Fixed Capital Formation (GFCF), Change is stocks and Valuables. GCF has contributed a 37.1% of GDP in FY09 (at constant price). GCF has grown at a CAGR of 13.7% during Fy01-09 period compare to GDP growth of 7.6% during the same period. During the same period, GCF has contributed 53% of GDP growth. This has resulted into a GCF/GDP ratio reaching a multi-year high.
GCF as a % of GDP, at constant price

Source: CMIE /CSO database
There are enough arguments to support increase in GCF/GDP ratio as well absolute increase in GCF over a period. Some of them are - India’s need for better infrastructure requiring huge investments in power, road, ports, irrigation, etc; increased consumption and better growth outlook mean continuous investment in new capacities; higher urbanization mean new realty projects; better service sector growth outlook (retail, IT, etc) means new offices and commercial realty projects, etc. True and valid arguments for long term, but closer look at data suggest that India has over invested in certain areas creating huge overcapacity for a next year or two.
Most notably is the GCF by manufacturing sector which has increase from 6.4% of GDP in FY01 to 14.5% in FY08, consisting of 40% of total GCF in FY08 up from 26% of GCF in FY01. Look at another analysis. Compare to a CAGR of 7.7% in GDP and a CAGR of 14.1% in GCF during FY01-08 period, machinery and equipment investments by private sector has grown at a CAGR of 20.1% and construction investment by private sector has grown at a CAGR of 26.4%. However, with growth outlook moderating or even worsening in many area of consumption, there is a possible overcapacity in manufacturing sector during FY09-11 period. Surprisingly, GCF in electricity, gas & water supply (one of the core infrastructure sector) has tracked GDP growth during FY01-08 period growing at a CAGR of 9.3%.
There is one more reason to disproportionate increase in GCF compare to GDP growth. Though, India’s saving rate is sufficient to fund capex up to 30-32% of GDP, India witnessed unprecedented amount of capital inflows during FY01-08 period thanks easy and low cost availability of capital and improved risk appetite for emerging markets like India – fueling unprecedented capex boom by Indian corporates. India received average USD 10 billion per annum in FY01-03 period and in FY08 alone received USD 100 billion. Today situation is different. Capital is scare and risk aversion has increased. Capital is flowing out of India and this may be one of the reason to expect a slow down in GCF to more sustainable 25-30% of GDP in coming years.
On Infrastructure investment front also things are not very bright. Government has estimated a total investment in various infrastructural sectors at USD 500 billion for FY08-FY12 period, but due to ongoing credit crunch many noted analysts are not expecting it to more than USD 270 billion. It means almost no growth in infra spending in FY08-10 period. There are sectors like residential and commercial real estate where yoy investment is likely to contract due to slump in realty market. There are sectors like railways and defense where GCF is still going to grow.
Change in stocksChange in stocks has grown at a CAGR of 33.4% during FY01-09 period compare to a GDP growth of 7.6% during the same period. In fact, ratio of change in stocks /GDP has increased from 0.7% in FY01 to 4% in FY09. A yoy GDP growth is 100 bps lower at 6.1 in FY09 if we exclude change in stocks. For, H2-09, yoy growth comes down to 4.7% if we exclude change in stocks.
Change in stocks as a % of GDP, at constant price



Source: CMIE and CSO
This clearly indicates a huge level of inventory across sectors and value chain. A mere de-stocking or right-stocking to 3.5% GDP in FY10 itself mean a negative contribution of 40 bps in GDP growth.

Capex holds on to previous level and some de-stocking of inventory
Capex spend and inventory level returns to normalize level
Abrupt de-stocking and new capex on hold due to deterring outlook


International trade – Export and Imports: tracking the globe India’s export has grown at a CAGR of 15.2% during FY01-09 period tacking the global growth and off-shoring opportunities whereas India’s import has grown at a CAGR of 18.5% tracking the domestic consumption and GCF growth. India’s export has grown on the backdrop of rupee appreciating from Rs 49 / USD level in 2001 to Rs 39 / USD level in 2007-08. Now rupee is back to Rs 48 / USD level and it is likely to provide some cushion to India’s exports. However, key question is – Is global demand growing? Answer seems to be No, as the world’s largest consumer – American consumer is in saving mode and is likely to save around 7-10% of it income compare to 0% savings few years back. Net result is likely to be contraction in global trade and India can not escape the reality. Rupee has weakened again the USD but so is the most of the other currencies. So, currency benefits to India is not meaningful as each country want some pie of remaining global demand to survive in the time of crisis. India’s imports will also slow – in short run due to moderating domestic demand, rupee depreciation and in long run due to India’s more self dependence of Oil and Gas due to recent discoveries.

US economy recovers from 1H-2009
Recession persist in US & Europe with some recovery from 2010
Recession in US & Europe worsen and domestic capex decline dramatically
Combining above matrixes, we arrive at FY10 GDP growth of 5.9% in optimist scenario, 3.4% in our base case scenario and just 1% in worst case scenario. Indian economy seems resilient in our optimist scenario; our base case expectation suggests that Indian economy is likely to fly into turbulent weather in FY10. Though right now we are ruling out possibility of a worst case hard lending scenario, we still prefer to remain downward bias from our base case scenario. Be prepared to ride the storm.

by Manish Marwah
www.sapphireconsultinggroup.in