Why India is on the cusp of a virtuous cycle

Risks to India's growth outlook are more external than domestic and cyclical than structural, like rise in oil prices or a slow pace of fiscal consolidation

With new infections on the decline and the pace of vaccinations picking up in India, an economic recovery is slowly underway. The recovery is still uneven and still some distance from becoming durable. However, with benign macro stability risks and strong growth rates, the country is well poised to enter a virtuous cycle like the period between 2003-07.

A recent report by Morgan Stanley suggested a virtuous cycle, supported by strong capex and productivity, is taking off in India. "This is a clear inflection in India's macro environment. Rising capex ratios will significantly lift employment prospects and boost income and consumption growth, creating a virtuous cycle," the report said. That the country is on a steady path to economic recovery is evident from a study by rating agency ICRA, which shows half of the indicators recovered above their pre-Covid levels in the second quarter (July-September) of the current financial year.

"We think that India's economy is well-positioned and ready for a takeoff in this cycle, given the global macro backdrop as well as supportive policy reforms. The risks to the outlook are more external than domestic and cyclical rather than structural in nature," the Morgan Stanley report said. The report expects GDP growth to be average seven per cent between FY23 and FY26.

Exports growth, one of the key drivers for steady economic growth, has been strong and will remain so as policymakers make concerted efforts to improve the business environment, incentivise corporate activity, and attract manufacturing investment. Led by manufacturing, capex to GDP ratios are seen rising six percentage points from FY21 to FY26.

One of the key reasons the country is on the cusp of a virtuous cycle is the government's policy, which has shifted from boosting consumption via transfers to boosting growth via investments. "Policymakers have been initiating reforms for a while now, and we believe that the economy is now in a good position to reap the cumulative benefits from past reforms," the note said.

The report cited Goods and Service Tax (GST), which was simplified after a clumsy rollout and eased compliance burden on the corporates. The corporate tax rate cut to 25 per cent and the production linked incentive (PLI) scheme where the corporate sector will get a tax benefit amounting to 4-6 per cent of incremental sales over the base year – are seen as the steps towards lifting investment and corporate profitability. India is also benefiting from global supply chain diversification as the PLI scheme helped foreign direct investment in manufacturing pick up.

External demand conditions are also expected to remain strong with exports growth strengthening. India, which lost market share since the outbreak of the Covid-19, has started to regain its share.

While the government is incentivising private corporate capex, it is also lifting fiscal spending on key infrastructure projects at the same time. The National Infrastructure Pipeline plan initiated by the government released a pipeline of projects in April 2020 and will span across FY 2020-25. "It will lift public and private infrastructure spending to an average 6.6 per cent of annual GDP in the period. As it stands, government spending (by both the Centre and states) has accelerated to a six-year high as of August 2021 on a 12-month trailing sum basis," the report said.

Notably, one of the conditions of any economic recovery to sustain is stable macroeconomic indicators. The report says that India's macro stability indicators are in good shape. Consumer price-index-based inflation is expected to stay within the Reserve Bank of India's tolerance zone of 2-6 per cent during the report's forecast horizon. "Cyclical developments will still matter for India's inflation outlook, and a faster pace of recovery will impart upside risks to our forecasts," it said.

On the external stability front, the current account deficit is expected to widen to 1.7 per cent of GDP in FY23, but the report says the deficit is likely to stay within the comfort zone, and the overall FDI flows will be able to fund the deficit. "Looking at it from a saving-investment gap perspective, even though we expect a rise in investment to GDP ratios, the productive nature of growth will mean that aggregate saving in the economy will rise too, limiting the widening of the current account deficit," the report said.

There is good news from the financial stability front also. After a prolonged rise in non-performing assets in the Indian banking system, bad loans started to slow down after peaking in FY18. The report noted that the Covid-19 shock did not result in bad loans, as feared initially, partly because of weak credit growth. Credit costs are projected to decline to 164 bps for FY2022 and further to 135 bps in the next financial year.

The risks to India's growth outlook are more external than domestic and cyclical than structural. For example, the US core PCE inflation significantly rising could lead to the US Fed's disruptive pace of rate hikes. Then, the RBI may have to raise interest rates more quickly than in the base case scenario.

A sharp increase in oil prices, driven by the supply side, is yet another risk. "India remains one of the key net importers of oil. Thus, a sharp increase in oil prices driven by the supply side would still pose risks to India's macro outlook," the report said.

A slower than expected pace of fiscal consolidation, which could affect inflation dynamics, is yet another risk. If such risks materialise, the RBI would have to tighten to a greater extent, which would, in turn, weigh on the private capex and growth momentum.

(The writer is a journalist)

Disclaimer: The views expressed above are the author’s own. They do not necessarily reflect the views of DH.