Economic outlook: GDP slump a warning bell for hamstrung policies

We believe that the confirmation of the Q2 GDP growth outlook should clear the air for policymakers to recalibrate their strategies, offering an anchor for basing the next phase of policy stimulus.

By Sonal Varma & Aurodeep Nandi

India’s GDP growth fell to a lower-than-expected -23.9% y-o-y in Q2 (Consensus: -18.0%, Nomura: -15.2%) vs 3.1% in Q1, led by a steep decline in domestic demand, and reflecting the impact of India’s stringent lockdowns. On a seasonally adjusted basis, we estimate that GDP fell -24.3% q-o-q vs +0.8% in Q1.

Private consumption demand contracted by -26.7% y-o-y in Q2, vs 2.7% growth in Q1, furthering a downtrend that has persisted since Q4 2018. Fixed investment unsurprisingly slumped to -47.1% y-o-y vs -6.5% in Q1, while government expenditure counter-cyclically picked up to 16.4% vs an already impressive 13.6% in Q4.

Government spending contributed 1.9pp to GDP growth vs 1.2pp in Q1, but both private consumption and fixed investments dragged GDP growth by -15pp each. On the external front, both export and import volume growth continued to contract. However, with imports contracting at a faster rate than exports, the contribution from net exports to headline GDP growth rose to a stellar 5.5pp vs -0.2pp in Q1. Overall, the hit to investment outpaced the hit to private consumption in Q1.

On the supply side, GVA growth slowed to -22.8% y-o-y vs 3.0% in Q1, below expectations. Agriculture GVA growth rose to 3.4% y-o-y vs 5.9% in Q1, largely unscathed from the pandemic, supported by higher winter crop production. As widely expected, industry GVA growth fell to -33.8% y-o-y vs almost nil growth in Q1, primarily reflecting the impact of lockdown on operations. Services also fell to a low of -24.3% vs 3.5% in Q1, with the lockdown freezing activity around construction and the “trade, hotels, transport, communication & broadcasting” segments. Finance, real estate and professional services surprisingly disappointed, contracting by 5.3% y-o-y vs 2.4% growth in Q1, despite relatively resilient trends in real deposit and credit growth. In addition, despite higher government counter-cyclical spending, the “public administration, defence, and other services” component contracted by 10.3% y-o-y vs 10.1% growth in Q1.

Why the negative surprise? We attribute this to three key factors:

1 The data come with considerable data collection caveats. It has been approximated based on unconventional sources owing to the restrictions resulting from the pandemic, and hence may be susceptible to further revisions.

2 The financial & real estate services sub-segment contracted vs our expectation of a rise, implying segments like real estate more than offset the improvement in banking sector indicators.

3 There has been a surprising divergence between the stellar growth in government spending on the demand side vs the sharp contraction in its counterpart on the supply side. A possible explanation could be that in the latter case, ~57% of the basket comprises of “other services”, which broadly comprises of education, healthcare, recreation, personal services and “private households with employed people”. The lockdowns may have caused a sharp fall in availability of these key services, accentuating the divergence.

Overall, the Q2 GDP data suggest a much sharper hit to domestic demand, with both private consumption and fixed investment growth hit more than expected due to the lockdowns. Despite the government’s parsimonious fiscal package of ~1% of GDP worth of direct spending, public expenditure growth remained strong, which led to an overall counter-cyclical response by the government. However, this was not enough to offset the slump in private domestic demand. While details are unavailable, we believe the steep fall in private consumption reflects weak demand for both consumer durables and services.

Looking ahead, after the sharp hit to activity in Q2, high-frequency indicators have improved further so far in Q3. Economic data point to an uneven recovery as of July, with a faster rise in supply (vs demand), rural consumption (vs urban) and industrial sector (vs services). We also find that the sequential pace of normalisation is moderating, suggesting that some sectors may plateau much before they reach their pre-pandemic levels. ‘Ultra’ high-frequency data for August so far, captured through the Nomura India Business Resumption Index find a more convincing pickup in August vs the stagnation in June and July, although remaining ~24pp below pre-pandemic levels.

The larger-than-expected contraction in Q2 leads us to cut our growth outlook. We are lowering our GDP growth projection to -9.0% y-o-y in 2020 and -10.8% in FY21. This would involve growth remaining in negative over the next three quarters (-10.4% in Q3, -5.4% in Q4, -4.3% in Q1 2021). The shape of the recovery will ultimately depend on the evolution of the pandemic curve and the recovery from the health crisis.

We believe that the confirmation of the Q2 GDP growth outlook should clear the air for policymakers to recalibrate their strategies, offering an anchor for basing the next phase of policy stimulus. If left unaddressed, a longer period of below-normal activity risks knock-on effects on the labour market, SMEs and ultimately on the banking system. The current economic status requires a more aggressive fiscal response, but budgeted fiscal support has been limited, while monetary policy is hamstrung due to inflation.

Despite the constraints, we expect accommodative policies to continue in three forms.

1 On the conventional monetary policy side, we believe the current stagflation scenario is transitory, and policy rates will be reduced by an additional 50bps cumulatively, starting in December when inflation eases.

2 The limited conventional monetary policy space effectively shifts the policy ball to the fiscal court, where we believe the second phase of support should be in the pipeline. The next round of policy stimulus is likely to be targeted and could take the form of an expanded scope of cash transfers, public employment programmes in urban areas, along with the continued focus on public investment. On our estimate, even with the current level of fiscal parsimony, the central fiscal deficit is likely to rise to ~7.8% of GDP in FY21, owing to a drying up of revenues and growth disappointment. States too remain in a fiscally precarious position, struggling from the loss of their own revenues and the absence of GST compensation cess—which will most probably lead to their fiscal deficit also blowing up to ~4-5% of GDP.

3 We expect fiscal-monetary policy co-ordination going ahead, as RBI endeavours to keep long-term government bond yields low, to ensure smooth financing of higher fiscal deficits. Secondary market government bond purchase is likely to be the first line of defence, but we cannot rule out debt monetisation. Our aggregate scorecard on the need for debt monetisation for India finds it at the top, reflecting high vulnerability to Covid-19, steep yield curves and high public debt. The Q2 GDP print also triggers the ‘escape clause’ under the FRBM Act, 2003, needed to allow for RBI to subscribe to primary issues of central government securities. Once triggered, it allows for ~0.5% of GDP of direct debt monetisation by RBI.

Edited excerpts from Nomura’s “Asia Insights” (dated September 1)

Authors are research analysts with Nomura Holdings. Views are personal