Where is the economy headed in 2018?

As the year draws to a close, the big question is, how will the economy perform in 2018? Will India regain the title of the fastest growing BRIC economy by inching ahead of China?

After reeling under the effects of GST and demonetisation, GDP growth in the September 2017 quarter showed signs of a pick-up. It clocked a growth rate of 6.3 per cent after sliding for five consecutive quarters. Whether the pick-up will gather further momentum or fizzle out remains a billion-dollar question. The government and monetary authorities are working towards getting Indian economy to its potential growth rate of 7 per cent plus in 2018 — which evaded us in 2017.

Bits-n-pieces

Forecasting GDP of the Indian economy for 2018 need not be an exercise of crystal ball-gazing. It requires analysing the prospects of various components. GDP — as per the expenditure method — is measured as a sum of Consumption, Investment and Government Expenditure (which in economic parlance is referred to as C + I + G). While consumption includes consumption by the households, investment refers to capital formation in the economy. Government expenditure includes Government Final Consumption Expenditure (GFCE) - spends made on items like education, health as well as salary and arrears. In addition, investments are also considered part of Government expenditure.

To the above figure, if one incorporates the external sector by way of net exports (exports minus imports), one arrives at the nominal GDP of an economy. Thus, in all, we could analyse the four components of GDP to gauge its robustness in driving the economic recovery for India. And since we are looking at estimating real GDP growth, inflation is another important factor that cannot be ignored.

Consumption

Consumption is the largest component of the Indian economy, constituting about 54 per cent of GDP. Post the note ban in November 2017, the worrying factor is that its share in the economy has fallen drastically (it was 59 per cent as of December 2016).

Consumption growth — as measured by growth in the private final consumption expenditure — fell consecutively in the initial three quarters of calendar year 2017. From a high growth level of 11.1 per cent in the December 2016 quarter, it fell to 7.3 per cent, 6.7 per cent and 6.5 per cent in the first, second and third quarter of this calendar, respectively. The note ban and GST implementation have had impact on household consumption in 2017.

With consumption being the primary growth driver of the economy, boosting it will be crucial to bring the economic growth rates back to 7 per cent levels. And in this, the Central government will play an important role. For instance, lowering GST rates of mass consumption products like detergents, aftershave and chocolate, which were in the 28 per cent tax rate, to that of 18 per cent could boost consumption.

Moreover, over the next one-and-a-half years, with eight State elections as well as General elections on the cards, rural consumption is expected to get a boost from the government’s populist measures. It is expected that the government will try to appease most sections of the society — be it farmers, traders, consumers or the poor — to get the votes.

While further farm loan waivers seem unlikely from the Central government, farm loan waivers announced by the various State governments as well as the effect of the Seventh Pay Commission payout at the state levels is expected to put more money into the pockets of consumers in 2018. Moreover, the la Nina forecast by the Australian weather bureau should bring good rains and further boost rural demand.

However, at the current juncture, consumer sentiment remains poor. The MasterCard India Consumer Confidence Index was at 86 as of June 2017, down from 95 in December 2016.

Demand for consumer durables seems to have been hit more; IIP (Index of Industrial Production) growth for consumer durables was a negative 1.8 per cent during the first nine months of calendar year 2017 as compared to 5.9 per cent witnessed during the corresponding period of the previous year. However, IIP growth for consumer non-durables remained strong — averaging 8 per cent in 2017 as against 7 per cent a year before.

Going forward, getting back to 8 per cent plus growth rate in consumption will be crucial to put the economy back in recovery mode. The consumer lending rate, which is currently at a multi-year low, should remain at lower levels to aid consumption. Higher growth in personal and credit card loans in recent times shows that consumption is set to improve next year.

Investments

Investments as measured by Gross Fixed Capital formation (GFCF) are the second most important constituent of the Indian economy. Saddled with excess capacity, the private sector, which comprises the bulk of the country’s overall investments, is currently sitting on the fence. Back-of-the-envelope calculations hint that India requires investment of about 35 per cent of GDP (investment rate) on a consistent basis to clock 7 per cent GDP growth rate. This is with the assumption that every ₹5 of investment results in an output of ₹1 (in technical terms, it is referred to as the Incremental Capital Output Ratio or ICOR).

While India showed initial promise by clocking investment rate of 36 per cent in late 2011 (and registering 7 per cent plus GDP growth rates), the investment rate is plunging now. The average investment rate for the first three quarters of 2016 was about 30 per cent as against 29 per cent in the corresponding period of 2017.

IIP growth (monthly average) halved to 2.7 per cent in the first nine months of 2017 as against 5.7 per cent witnessed during the corresponding period of the previous year. IIP y-o-y growth in manufacturing also slowed down to 2 per cent in 2017 as compared to 5.7 per cent a year before.

Excepting auto, pharma and computer & electronics, the IIP growth figure was lower in 2017 as compared to 2016 for most of the other sectors. Textiles, leather, chemicals and chemical products, basic metals, electricals, coke and refined products and machinery were among the laggards.

Also, the Purchasing Managers Index (PMI) figures — usually out before the industrial output and GDP figures — indicate that while manufacturing PMI was up in November 2017 to 52.6 as compared to 50.3 in the previous month, the services sector PMI dipped below 50 (48.5), indicating contraction of business activity. PMI (composite) averaged 50.6 in the first 11 months of 2017, as compared to 52.5 in the corresponding period of the previous year.

Credit slowdown

In all, industrial activity is not showing any concrete signs of pick-up for the moment. Moreover, credit growth has slowed down — thanks to excess capacity and banks’ aversion to lend. The credit growth of scheduled commercial banks to the industry stood at -0.2 per cent (October 2017 vs October 2016) as compared to -1.7 per cent in the corresponding period of the previous year.

Bank recap

While the capex cycle is unlikely to change over the next year, the government is trying to enable credit offtake by recapitalising public sector banks to the extent of ₹2,10,000 crore. This is expected to be completed by the end of FY19. While part of the money will be used to clean up bad loans, the rest is expected to boost credit growth.

However, given that banks will need to take huge write-offs, particularly on large NPA accounts, getting back to the healthier credit growth rate of 16-18 per cent seems unlikely in 2018 given the challenges of overcapacity and risk emanating from possible increase in interest rates. Investments will therefore continue to be a drag on the economy. It will continue to remain at levels similar to 2017.

Government spends

The share of government consumption is relatively smaller — 12-13 per cent of GDP. However, it has been up sharply in 2017 on the back of increased spends by the Centre. In the initial three quarters of 2017, its growth averaged about 18 per cent as compared to 12 per cent a year before. After clocking high growth rates in the first two quarters of 2017, it fell sharply for the September quarter to 4.1 per cent.

Further, a tight fiscal situation might lead to a cut in government spends to meet the fiscal deficit target set for 2017-18. There are signs of slowdown in revenue collection. For the period April-October ’17, revenue receipts were about 48 per cent of budget estimates (for 2017-18) as compared to 51 per cent amassed during the corresponding period of the previous year.

While tax revenues were higher at 52 per cent of budget estimates (for 2017-18) as against 50 per cent a year before, non-tax revenues were down to 33 per cent as against 52 per cent a year before. Less dividends from the RBI (thanks to demonetisation) played spoilsport, reducing non-tax revenues to the extent of ₹35,000 crore in 2017-18 for the Central government.

Moreover, after the reduction in GST tax rates for several household items, the monthly GST collections, according to reports, were down to ₹83,000 crore in October ’17 as compared to ₹93,000 crore it clocked every month during the period July-September ‘17. This could impact the fiscal situation as well its spending power.

While it is likely that the government will make do the shortfall by pushing disinvestment, the risks of lower GST collections remain in addition to expected shortfall in collections from the telecom sector. In all, with overall finances appearing dicey, Central government consumption spends are expected to be muted in 2018.

Inflation

So far, consumer inflation has been well within the RBI’s target of 4 per cent (plus/minus 2 per cent) . CPI (Combined) averaged 3 per cent in 2017 during the first 10 months of 2017 as compared to 5.3 per cent in the corresponding period of the previous year.

While housing and fuel and lighting were up sharply in 2017, food and clothing were lower in 2017 compared to a year before.

Moreover, there is the greater risk of inflation being stoked due to increase in input prices for producers, which will ultimately be passed on to the consumers. Monthly WPI inflation averaged 3.3 per cent in 2017 as compared to a negative 0.5 per cent in the previous year. WPI inflation is up for manufacturing, fuel, power & lighting as well as crude petroleum & natural gas.

For starters, crude oil prices are on the way up, risking import-led inflation for the economy. Moreover, food inflation is also inching up with prices of tomato, onion and eggs soaring in recent months.

Going forward, while food inflation is expected to come down with cooling of vegetable prices, the risk of rising international crude oil prices remains a worry. Moreover, with the Centre already hitting 96 per cent of the 2017-18 fiscal deficit target in October 2017 itself, the targeted fiscal deficit might be breached — risking inflationary trends for the economy. The Centre was targeting a fiscal deficit to GDP ratio of 3.2 per cent for FY18 and 3 per cent for FY19.

Economic outlook

To sum up, consumption will lead the economy on the recovery path, taking it towards the 7 to 7.2 per cent growth in 2018 from 6.5 per cent expected in 2017. While investments are likely to remain muted, any surprise performance from the manufacturing sector can push GDP growth levels.

Incidentally, the SBI Composite Index was up slightly in November to 51.2 — indicating expansion of manufacturing activity. While the external sector is unlikely to turn around and be a game-changer, there are risks of inflation delaying the recovery. Especially, with elections on the cards, it seems fiscal prudence will give way to populism — risking worsening of the fiscal situation.

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