By Invitation. Slow and steady does it

In some ways, 2015 was a damp squib. Exactly a year ago, exuberance was rife regarding India’s economic prospects because of falling commodity prices, a reform-oriented government and an inflation-focused central bank. A year later, the balloon of enthusiasm has partially deflated.

There is disappointment about the pace of growth. Concerns around the US rate cycle and China growth have hurt flows into emerging markets. What next? We look at the five key themes that we think are likely to shape the Indian economy in 2016.

India is already in the initial stages of a business cycle recovery. We expect this to continue in 2016 — with GDP growth rising to 7.8 per cent from 7.3 per cent in 2015. However, that growth will be driven by a faster rise in consumption, rather than capital expenditure (capex).

Higher real disposable incomes, lower borrowing costs and the income boost from the Pay Commission hike will further boost urban demand. Rural demand should also improve, if monsoon is normal. Meanwhile, the government’s thrust on infrastructure investments may be constrained given the added burden from the Seventh Pay Commission, while under-utilised capacity in the manufacturing sector is likely to prevent a substantial acceleration in private sector capex.

The investment recovery will be mainly led by implementation of stalled projects, FDI inflows and off-balance-sheet financing via public institutions. At the margin, consumption demand should outpace capex demand.

After falling sharply in 2015, we expect CPI inflation to average 5.4 per cent in 2016 from 4.9 per cent in 2015. The steep rise in housing allowances for Central government employees will directly push up CPI housing in the second half of 2015-16.

However, excluding this technical rise, we believe that underlying inflation is likely to meet the central bank’s 5 per cent inflation target for March 2017, as lower oil prices, weak rural wage growth and ample manufacturing spare capacity offset the upside risk from rising discretionary demand.

We expect the RBI to deliver a final 25 basis point repo rate cut in Q2 2016, although an inter-meeting cut cannot be ruled out. Beyond this, with inflation expectations still elevated and little headway in farm reforms, it will be challenging to lower inflation to the RBI’s medium-term inflation target of 4 per cent (March 2018), particularly with the output gap likely to close gradually.

The government’s objective of fiscal consolidation without compromising the quality of consolidation looks challenging. The once-a-decade hike in government employee salaries and pensions will be implemented in 2016 (due from January 2016) and will add 0.5 per cent of GDP to the Centre’s wages and pension Bill in FY17.

The “one-rank-one-pension” scheme will cost another 0.1 per cent of GDP. Add to that the 0.4 per cent of GDP fiscal consolidation envisaged (from 3.9 per cent in FY16 to 3.5 per cent in FY17) and it becomes clear that the government needs to create savings and additional revenues of almost 1 per cent of GDP.

Higher tax collections from excise duties on petroleum products, a hike in the service tax rate and significantly higher asset sales can partly plug the gap, but the fiscal deficit target of 3.5 per cent of GDP cannot be achieved without a slight cutback in capex. The government will have to increase its dependence on off-balance-sheet sources of financing of infrastructure projects.

Low commodity prices remain a positive for India’s external sector. Despite the divergence between domestic (faster) and global (sluggish) growth, we expect India’s current account deficit to narrow to 0.5 per cent of GDP in 2016 from 0.7 per cent in 2015. Moreover, financing the current account deficit should be even easier. We expect net foreign direct investment inflows to rise to 1.6 per cent of GDP in 2016 due to strong pull factors (relaxation of FDI norms, emerging new growth avenues like e-commerce, Railways and renewables, improving domestic growth) and push factors (slowing China).

Our State-wise analysis shows that, although the NDA’s strength in the Upper House should improve from around 65 in 2015 to around 80 by the end of 2016, it will remain short of a majority. Thus the government has to build a consensus to pass legislative reforms. Global investors are overweight on Indian equities and the government has to corroborate this trust.

Among legislative reforms, the GST Bill remains the litmus test. Strategic disinvestments from loss-making PSUs, the Bankruptcy Code and amendments to the RBI Act are other key reforms that could help. However, the State elections in Kerala, Tamil Nadu, West Bengal and Assam this year may slow policy announcements in Q2 2016. Overall, we do not expect any fireworks, but a gradual growth recovery and benefits from lower commodity prices may support the slow and steady cycle in 2016.

The writer is Chief India Economist, Nomura. With inputs from Neha Saraf, India Economist

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