The downward correction in global oil prices and US dollar/interest rates from their highs offered a reprieve to emerging markets, particularly India, in the final quarter of 2018. Asset markets are, however, far from breathing easy. Regional data points to an impending growth slowdown this year, led by weaker exports and magnified by the US-China trade skirmish. The Indian markets are also on tenterhooks, at a time when domestic catalysts are gaining importance.
In this column, we will address five crucial questions facing the Indian economy this year. Lower oil prices, alongside a softer but stable growth environment, has added to the disinflationary spell. Policy tightening expectations have fizzled out, but the fiscal outlook and politics still bear watching.
Gains from Lower Oil Prices
The Indian basket of crude oil prices corrected by more than 30 per cent from the peak in early October. This will provide some reprieve for current account and balance of payments positions in FY2018/19. Every 10 per cent rise in oil prices is estimated to widen the current account deficit (CAD) by 0.4 per cent of GDP. Oil prices have averaged $72 per barrel so far in the first three quarters of the current fiscal, below our assumption. If this is maintained, CAD could come in at 2.5 per cent of GDP in FY19, narrower than our forecast of -2.7 per cent. The balance of payments (BOP) deficit will, similarly, narrow by $15-20 billion instead of around $25 billion earlier. Further relief to the BOP will require a deeper correction in oil prices as well as better risk appetite to reverse capital outflows.
However, inflation is unlikely to be swayed significantly by the recent pullback in oil prices. India's domestic fuel tax structure only allows a partial pass-through of the sharp correction in international benchmarks. Moreover, food prices have been a bigger driver of inflation of late. For growth, low oil marginally improves the room for discretionary spending and lower input prices.
Inflation: Lower for Longer?
India's inflation has remained stable within its official 4?2 per cent target band after the plunge in global prices in 2014/15. The disinflationary spell in FY19 has been notably dramatic - CPI inflation fell from 4.9 per cent YoY in April-May, 2018, to 2.3 per cent in November. Disinflationary pressures from the food segment overwhelmed firm inflation in the service sector. The erstwhile high core inflation is also bound to correct on cuts in domestic fuel prices, negative base effects, slowing growth and waning impact of administrative changes. Food disinflation stems from weaker cues from global farm commodities along with domestic oversupply and inefficient procurement strategy for crops under minimum support prices (MSPs). Reasons behind this slump vary from seasonal fluctuations to higher imports and export restrictions in some cases, which have increased domestic supply.
With supply-demand dynamics pointing to a soft phase for food inflation (50 per cent of the basket), this will continue to offset intermittent bouts of imported price pressures (oil and rupee). The evolving inflation trajectory for FY19 suggests that headline inflation might stay below 3.5-3.8 per cent until March 2019, posing downside risks to our full-year forecast of 4 per cent. In FY20, inflation is seen at 4.2 per cent, factoring in a modest increase in food inflation on pro-farm support measures, steady commodity prices and negative base effects from this year.
Impact on Monetary Policy
The ground to change the stance to 'neutral' from 'calibrated tightening' was first laid at the last policy review on December 5, 2018. The policy panel under former RBI Governor Urjit Patel has downgraded its H2FY19 inflation forecast to 2.7-3.2 per cent from the previous 3.9-4.5 per cent and kept H1FY20 forecast at 3.8-4.2 per cent or around its 4 per cent medium-term target.
Besides a benign inflation forecast of 2-2.8 per cent in the coming months, the remarks of the new Governor Shaktikanta Das and a commitment to keep the fiscal deficit close to its FY19 target of -3.3 per cent of GDP will be closely watched for a shift to a neutral stance at the next RBI review on February 6. With real rates high on below-target inflation, expectations have emerged for a rate cut at the April review. But this will not be the beginning of a new easing cycle. Inflation is set to return above 4 per cent in FY20 on base effects amid an uncertain global backdrop.
Fiscal Slippage Risks
During April-November, 2018, the central government's fiscal deficit has already been 15 per cent higher than the total FY19 target, more from a revenue shortfall than a front-loading of expenditure. Although tax revenues have been seasonally strong in the second half, net direct tax collections have only reached the halfway mark, with four months left in FY19. GST revenues, based on the current monthly run rate, are also set to miss the annual target by Rs 70,000-80,000 crore. Divestment efforts need to be kick-started as well. Also, the year-to-date collections have only hit a fifth of the target on the disappointing appetite for IPOs. For the rest of the year, plans are under way to offload minority stake sales, conduct share buybacks and ETFs, and possibly merge power sector financing firms.
While this deterioration in the fiscal math is not completely out of sync with the past years, a moderation in indirect revenues has also become a concern. The approaching national elections will reduce the likelihood of fresh revenue-generating measures amid higher spending needs. Addressing rural distress and lowering the economic pain from GST adherence are among the immediate priorities. Speculation is that the government might introduce a rural benefit package, the cost of which is pegged at Rs 2.3 lakh crore (1.2 per cent of GDP). While the impact of any such scheme will be apparent in FY20 fiscal math, this year, any slippage might be limited to -3.5 per cent of GDP. Expenditure compression is on the cards in FY19, also helped by the freeze that routinely takes effect in the final quarter of the year. However, quality of the consolidation efforts will be questionable due to revisions in the FY19 Budget economic indicators, the postponement of spending items and prevailing accounting methodology. For FY20, the authorities might stick with the -3.1 per cent target under the recommended glide path, assuming greater traction in GST revenues from a wider tax base and improved compliance, and steady commodity prices. Either way, the budget presentation on February 1 will be an interim version, ahead of the April-May general elections.
Our in-house GDP Nowcast model, which uses the latest available key statistical data under an autoregressive forecasting framework, has signalled a slowdown in the growth momentum. Due to adverse base effects in mid-2019, growth will revert to mean in the coming quarters. The cyclical slowdown will also extend in the second half of FY19 owing to limited fiscal room, tight financial conditions and weak farm incomes. Easing oil prices will reduce the drag from sub-par trade, but slower global growth and a firm real rupee might constrain exports at the margin.
While the early impact of the trade dispute will be visible in the regional trade performance in the first quarter of CY2019, the relatively smaller dependency of India's growth on the external sector is expected to shield the economy from any direct impact of deterioration in the US-China trade relations. From 7.7 per cent in 1HFY19 (April-September, 2018), we expect India's 2H real GDP growth to average 6.6 per cent, arriving at our full-year forecast of 7.1 per cent. As demonetisation and GST-driven base effects fade, growth is likely to slip into a softer yet stable growth trajectory. We look for FY20 growth at 7.4 per cent YoY.
The political environment will also be watched closely after the ruling party suffered setbacks at the recent state elections. History suggests that state polls provide a foretaste, but these are, by no means, conclusive for the coming general elections. For the markets, political uncertainty poses a short-term hurdle, offsetting some of the positive impacts from the sharp drop in oil prices and easing rate volatility. In the long term, corporate earnings will still be the predominant driver for the broader market direction.
The global landscape remains a key wildcard. Factoring in our current expectations of a US Fed tightening cycle to continue into 2019, with an eye on the end of the 90-day waivers on oil exports from Iran by 1QCY19, the direction of oil and USD/rates will be watched closely.
The writer is Vice President and Economist at DBS Bank, Singapore