India: Monsoons dominate growth outlook

Concerns over the monsoons are once again highlighting the importance of rainfall and agriculture to the Indian economy. Although the southwest Monsoon has revived in August, poor performance during July has harmed overall prospects for the largely rain-fed agriculture sector this year, as July is an important month for sowing certain crops.

Agriculture is a key driver of the Indian economy, directly accounting for 22% of GDP, but having a more pervasive impact through rural demand. We now expect agriculture to show little improvement on its exceptional growth in FY2003/04, and have accordingly reduced our GDP forecast for FY2004/05 to 6%.

India's still robust growth is driven by continued momentum in the industrial and services sectors. Industrial output expanded by 7.3% in the year to June. This was underpinned by strong growth in the capital goods sector (18% y/y), adding weight to evidence of an investment recovery that the new United Progressive Alliance (UPA) government is anxious not to de-rail.

FY2004/05 budget encouraging

The UPA's first budget provided some comfort that India's reform process will continue, despite the coalition's reliance on the support of less reformist left-wing parties.

Expenditure increases to fulfil the policy goals of the coalition were lower than widely feared, and funded from higher forecast revenue. Lower targets for the central fiscal and revenue deficits were set in line with the Fiscal Responsibility and Budget Management Act (FRBM).

There was a clear emphasis on attracting foreign investment and more extensive tax reform was promised for the 2005/06 budget, by which time the Congress-led coalition should have gained more confidence.

However, the criticism from the left-wing parties over raising foreign investor limits on particular sectors is indicative of the resistance faced by the pro-reformers.

We expect pragmatism to prevail, but the reform process to be slow. The more immediate concern is the ability of the government to meet its revenue growth targets, which relied more on robust GDP growth than structural reform.

Global environment becoming less supportive

With high oil prices and rising US interest rates, the global environment is becoming less supportive. However, India's balance of payments should remain fundamentally sound.

A current account surplus is forecast for FY 2004/05 as robust visible export growth, stable remittances and the expansion of software and IT-enabled services continue to offset the impact of high oil prices on imports.

Given current global conditions, corporate sector covering of short dollar positions will keep the balance of payments under pressure near term. Capital inflows will inevitably be lower in FY 2004/05, due to tighter global liquidity, lingering concerns over government policy, and more limited privatisation.

However, India is still a high growth market. Portfolio flows and deposits by non-resident Indians (NRIs) should stay healthy.

The key risk to the outlook is the direction of the USD. Dollar strength along with rising US interest rates is a potent combination that could prompt domestic monetary tightening.

We expect a weaker USD underpinned by structural imbalances and the prospect of slowing US growth in 2005. Given India's sound fundamentals, we expect the current real effective exchange rate range to hold and are forecasting the INR to reach 45.20 by year-end. This will allow policy rates to remain on hold, domestic conditions permitting, until 2005.

Commodity prices driving inflation higher

Wholesale price inflation rose to 7.61% y/y at the end of July, from a low of 4.3% in April, driven by oil and other commodity prices.

We expect commodity prices to remain firm, but baseline effects should bring inflation lower beyond August, more than offsetting rising prices of agricultural commodities. Demand-led inflationary pressures are not yet evident, despite strong growth.

Given the narrow source of inflationary pressure, uncertainty over global conditions and a clear desire to sustain economic growth, a pre-emptive rise on policy rates to contain inflation is unlikely at this point. The recent cut in duty rates on petroleum products was a logical first step.

Helen Henton, Chief India Economist
Kishlaya Pathak, India Economist