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India Economics: Glorious and delicate

 7 Dec 2023

Key takeaways

  • Growth momentum is strong, food inflation uncertain, and FDI flows shifting frontiers.
  • We expect the RBI to continue with tight monetary policy during this time.
  • ...keeping policy rates unchanged, liquidity tight, and tweaking macro prudential norms where it senses excesses.

Notwithstanding the recent weakening in the dollar, the global and Indian economy are at crossroads on many fronts. In this environment, we believe the RBI will opt to keep monetary policy tighter for longer, particularly in its upcoming 8 December meeting. 

We expect the repo rate to be on hold at 6.5%, and for liquidity to remain tight with the call money rate trending higher than the repo rate. We also expect the stance to remain unchanged i.e. “withdrawal of accommodation” given liquidity remains tight. The RBI may focus more on tweaking macro prudential norms, to address some excesses in the system. It has already raised risk weights on certain lending. 

We see many reasons for a continuation of tight monetary policy: 

Changing flows. India is at a crossroads on various fronts. Portfolio inflows are exhibiting renewed momentum, but FDI inflows have fallen sharply. India may be at an interesting crossroads, where pandemic-led FDI flows in sectors like computer services,  drugs, and pharmaceuticals have slowed, but investment intentions reveal meaningful interest in futuristic sectors like renewables, semiconductors, and AI. But until these flows come to fruition, the RBI may be sensitive to a falling balance-of-payment surplus and its impact on the currency, thereby keeping monetary policy tight.

Evolving inflation. In good news, core inflation has finally started falling after a long wait, but food inflation remains uncertain in an El Niño year. Reservoir levels are low, and a recent vegetable price spike means that the next two inflation readings could be close to 6% (from 4.9% in October), before moderating on the back of the winter vegetable disinflation. But where it rests then will depend a lot on the winter wheat crop, and that may not be clear until March. Until then, the RBI may want to err on the side of caution in its treatment of rates.

Glorious growth. The GDP growth momentum is strong as evidenced by the 7.6% growth clip of the September quarter. We believe that even though growth could slow by c150bp from 1H to 2HFY24, the majority of that would be led by statistical reasons. Actual growth may not soften much, leaving the RBI on its toes.

We believe the RBI will continue to maintain tight monetary policy at its 8 December meeting. We see many reasons for this, which we discuss below.

Changing flows

India’s global footprint is deepening. It is not just that its GDP growth is rising sharply, but its share of global goods and services exports has risen. After turning negative for a few months, equity inflows shot back up in November (at USD1.1bn). Inflows into the debt market have also become buoyant (USD1.8bn in November), especially after the JP Morgan Index Inclusion announcement.

All of this stands at odds with the fall in India’s FDI inflows. On a year-to-date basis, FDI inflows have fallen to USD4.5bn this year vs USD19.6bn last year (Chart 1). India’s share in global FDI has also fallen. All of this, alongside a rising current account deficit, may push the balance-of-payments into deficit (Chart 2).

We looked closely and found that FDI inflows may be at a crossroads. One – the pandemic-led demand for some goods and services like drugs and pharmaceuticals, and computer services led by rising work-from-home, may have softened. No surprise then that FDI inflows in these sectors have also slowed (Chart 3). Two – as per some metrics, China has become a net direct overseas investor since early 2023. Its investments are spreading across continents – ASEAN, the Middle East, Europe and Latin America. But not much in India. In fact, we think India’s FDI is at a crossroads as sectors in the spotlight are changing, as are the providers of FDI.

And yet, India’s FDI outlook remains positive. The investment intention data we track continues to rise. It is also becoming more diversified across various sectors. Even if India is not getting certain country-led flows– as per investment intentions – it  could get compensated for by other country-led flows in newer sectors. For instance, Abu Dhabi announced a renewable energy USD30bn fund on 1 December, and listed India as a key market.

But while India stands at the FDI crossroads (with pandemic focused sectors receding and futuristic sectors rising), the RBI may be sensitive to the balance-of-payments and its impact on the currency, keeping monetary policy tight.

Source: CEIC, HSBC
Source: CEIC, HSBC estimates
Source: CEIC, HSBC
Source: OECD, HSBC
Source: CEIC, HSBC
Evolving inflation

In good news, after staying elevated for an extended period, core inflation has come down to sub-5% levels across the various definitions (Chart 5), and the diffusion index shows that only 50% of the core items have inflation of more than 4%.

Having said this, we need to watch the decline in core inflation closely as it has come even before the economy has slowed. The natural direction of travel is rate hikes slowing the economy, which in turn slows inflation. Also the housing index data in the CPI basket is not meeting the smell test. Anecdotal evidence points to rising house prices and rentals, but housing inflation has been at the pre-pandemic level of 4.5% y-o-y.

And food inflation pressures are too widespread to ignore. In November, 50% of   food items saw higher inflation than in October. These include cereal, pulses, vegetables, fruits, sugar, and spices.

Reservoir levels are low and cereal stocks, too, are at low levels (Charts 6 and 7). Cereals matter. Given its importance in the food basket (having a weight of c20%), we find that once it rises, it remains elevated for a few quarters, and even spills over into core inflation (Chart 8). 

Given the price spike in some vegetables in November1, the next two inflation readings are likely to  be around 6%, before moderating on the back of winter disinflation. But where it rests then will depend a lot on the winter wheat crop, and this will only become clear in March.

Until then, the RBI may want to err at the side of caution in its treatment of rates. 

Source: CEIC, HSBC
Source: CEIC, HSBC
Source: CEIC, HSBC

Glorious growth

The September quarter GDP growth came in at a higher-than-expected 7.6%, signifying the strong growth momentum in the economy.

Sure, there were sectoral divergences. For instance, urban demand zipped ahead while rural slowed (Chart 10). Industry and manufacturing outpaced services (Chart 11), while investment outpaced consumption.

Then, there was the case of statistical exaggeration of numbers because of the practice of single deflation instead of double deflation, which tends to exaggerate growth in times of falling commodity prices; something we have been writing about for a while. We also believe there were low base effects coming from the pandemic period, which led to high GDP numbers in 1H, but would dissipate in 2H (Charts 12 and 13).

And falling FDI (even if temporarily), a weakening agricultural sector, and any softness in credit growth could, over time, lower the growth momentum.

But because the momentum is so strong, we do not expect growth to slow sharply. Government capex could fall, but some of it may help create space for current expenditure. Credit growth could ease, but may not fall sharply given structural improvements in access. FDI has fallen, but could get compensated, to some extent, by other flows.

We believe that even though growth could fall by c150bp from 1H to 2H, about 100bp out of that would be led by statistical reasons, for instance the y-o-y fall in commodity prices lowering and the low base effects normalising.

Actual growth may not soften much, leaving the RBI on its toes.

Source: CEIC, HSBC
Source: CEIC, HSBC
Source: CEIC, HSBC estimates
Source: CEIC, HSBC estimates

Market-supportive state election results

Of the four state election results that were announced on 3 December, the BJP won three –Madhya Pradesh, Rajasthan, and Chhattisgarh – with a showing that was better than expected. These three states make up an important part of the Hindu heartland. The Indian National Congress party won the fourth state, i.e. the southern state of Telangana.

While the state elections do not give a perfect indication of what can happen in the national elections in May 2024, markets may interpret it as an indication that the BJP has a good chance of winning the national elections as well, paving the way for Prime Minister Modi to return as India’s Prime Minister for a third term. More perceived certainty on the results may lower the risk premium on asset prices going into the national election year.

Rates, liquidity, macro prudential norms

The RBI has been gradually broadening its toolkit – from raising rates, to tightening liquidity, and finally to strengthening macro prudential norms – in its efforts to maintain macroeconomic stability at a time of global volatility.

  • Rates – we expect the repo rate to remain unchanged at 6.5% for the next several quarters. We believe that some space to cut rates may open up in mid-2024, but it will be limited to 1-2 rate cuts of 25bp each. Anything more than that may lead to rate hikes down the line given India’s strong growth outlook.
  • Stance – We believe the “withdrawal of accommodation” stance will continue as of now, when the RBI is focused on keeping liquidity tight.
  • Liquidity – The RBI had kept liquidity tight, and engineered an additional rate hike, with the call money rate at around 6.75%, which is 25bp higher than the repo rate in the run up to the October meeting. Recently, the call money rate has risen even more, averaging 6.8% over the last 10 days of November, as liquidity has fallen further, led by high government balance, currency in circulation leakage, and RBI dollar sales. We believe the call money rate could soften from these high levels as the government spends, but is still likely to remain in the 6.25% ballpark for the next few months, or until inflation uncertainties abound. 

Macro prudential norms – on 16 November, the RBI announced higher risk weights for unsecured consumer credit, as well as bank lending to NBFCs, to temper the rapid growth in this sector, which had touched a growth clip which was 4-times nominal GDP growth. We believe the RBI will be tracking the data to determine if further action is needed. In the meantime, the RBI would also look at other areas that may require some degree of intervention, for instance hedging activity by corporates, (which may have fallen at a time of INR stability vis-a-vis the dollar).

Related Insights

Despite a rising share in global trade, and buoyant foreign investment intentions, FDI inflows into India have surprisingly slowed...[22 Jan]
Growth has proved resilient, and inflation has dropped…[8 Dec]
India’s consolidated fiscal deficit remains above pre-pandemic levels even though growth...[15 Nov]

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