Centrum: India Economy Deepening cyclical downturn and beyond

GDP forecasts scaled down With the G3 economies in recession, cyclical risks to India’s growth have deepened, motivating us to cut our growth projections. We have therefore scaled down our GDP forecast for FY09 and FY10 to 6.5% and 6.0% from 7.0% and 7.5% earlier, respectively. We see recovery emerging around the H2FY10, which will strengthen in FY11 with growth moving up to 7.5%. Our cyclical downdraft view is primarily driven by the weakening consumption demand, rising factor costs, drying up of savings, pressure on external balance, which have led to the slower investment demand (Heading for a cyclical slowdown, May 28 and Cyclical slowdown before a turn around, June 4). These factors have intensified more than anticipated.

Reflationary strategy will have limited multiplier impact We are less sanguine on the recent reflationary policies. Growth revival will require a longer process involving reallocation of resources and multiple price and output adjustments. Rationing of credit will continue as credit risks remain elevated. While additional budgetary spending will enhance immediate demand, its growth multiplier impact will be limited.

An ablution phase before the next growth cycle We expect the next growth cycle to emerge following multiple macro adjustments over the next 18 months. These include realignment of investment rate to falling saving rate, declining inflation in response to weakening pricing power and softening commodity prices, considerable decline in credit demand and balance sheet restructuring.

Next cycle to start shaping up in H2FY10 and gain momentum in FY11 In our view, the key driver for the next cycle, which we expect to start showing up in H2FY10, will be strong productivity growth emanating from cost efficiency, rationalization of balance sheet, reduction in input costs and inventory correction. Aggregate demand is expected to revive on expected fiscal allocation on capital spending and lagged impact of monetary easing. We expect next investment cycle to revive in FY11 and will be preceded by bounce back in domestic savings rate and external capital flows.

Growth outlook: Longer downdraft delays recovery prospects We have reviewed our GDP growth estimates for FY09 and FY10, in view of the aggravation of domestic cyclical risks arising largely from the spill over effects of recent global and financial dislocations. We have scaled down our FY09 and FY10 GDP forecasts to 6.5% and 6.0% from 7.0% and 7.5%, respectively. We see recovery emerging around the second half of FY10, which will strengthen in FY11 with growth climbing to 7.5%. In our earlier reports (Heading for a cyclical slowdown, May 28 and Cyclical slowdown before a turn around, June 4), we had elaborated on the key cyclical drivers for growth slowdown in FY09 and a modest revival in FY10. We attributed these to moderate recovery in consumption demand, despite subdued investment demand. With G3 economies already into a recession and given India’s strong global financial linkages, the risks we have been highlighting have intensified since our last call. The key differences arise from stronger-than-expected deterioration in external capital flows (reflected from the sharp US$58bn decline in forex reserves during the current fiscal) causing tight liquidity, severe weakening in equity market activities restricting fund raising activities, deteriorating external demand and decline in prospective investment demand. In light of these developments, we now expect a sharper slowdown in growth rate and recovery cycle to take longer-than–expected (earlier we expected recovery to start from H1FY10), which underpins our downgrades.

Identified risks have aggravated and will delay recovery Earlier we highlighted our cyclical slowdown argument and focused on the following themes (Heading for a cyclical slowdown, dated May 28)
1. Flagging consumption demand, rising factor costs and drying up of surplus savings likely to impact investment decisions. Domestic savings rate expected to scale down due to worsening fiscal conditions and weaker profitability. External savings were also expected to come under pressure.
2. In the medium term, we expected savings rate to slow down and difficulty in funding of investment demand. While data on ongoing and proposed projects looked strong, we saw a strong risk of project delays and postponements.
3. Monetary tightening along with correction in retail credit boom, moderation in compensation growth and deceleration of activities in manpower intensive sectors was expected to hurt consumption. A correction in the asset prices, including property, was expected to weaken disposable and perceived future incomes.
4. A combination of slower consumption demand and moderating investments was expected to slow growth over the next 12-18 months. Continued support from investment demand seemed bleak, as the investment cycle was still far away from the bottom.

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