The economic recovery has progressed well over recent months and as things currently stand growth is on course to be stronger than the consensus expects this year. But the recent surge in virus cases is a significant downside risk to the outlook. It is also a key reason to think that the RBI will be in no rush to withdraw policy support. We think that markets are too hawkish in pricing in rate hikes during the next 12 months.
- Overview – The economic recovery has progressed well over recent months and as things currently stand growth is on course to be stronger than the consensus expects this year. But the recent surge in virus cases is a significant downside risk to the outlook. It is also a key reason to think that the RBI will be in no rush to withdraw policy support. We think that markets are too hawkish in pricing in rate hikes during the next 12 months.
- Output & Activity – Household spending and investment will continue to lead the recovery but the new virus outbreak threatens to hamper activity in the near-term.
- External Stability – The current account reached its largest surplus on record in 2020. Though the deficit should return over the coming quarters, external risks will remain manageable for the foreseeable future.
- Inflation – A rise in headline consumer price inflation is likely over the next few months but it will largely be driven by fuel prices and so prove temporary. Further ahead, a (likely) bumper winter harvest and a still-large output gap should help to anchor inflation.
- Fiscal & Monetary Policy – The RBI will not be in any rush to tighten monetary policy while the economy remains well below potential. Meanwhile, this year’s substantial loosening of fiscal policy will provide an important prop to growth, albeit at the expense of a larger public debt burden. Authorities are increasingly likely to implement measures to keep bond yields in check.
- Long-term Outlook – The COVID-19 crisis will leave a legacy of higher debt and fragile banks in India, but demographics and reform still point to strong future growth.
Key India Forecasts
(unless otherwise stated)
Output & Activity
External Sector (% of GDP)
Current Account (4Q Sum)
Fiscal (% of GDP)
Central Government Balance1
Gross Government Debt
Monetary (end period, %)
Reverse Repo Rate
Cash Reserve Ratio
Markets (end period)
5-yr Government Bond (%)
10-yr Government Bond (%)
Brent Crude ($/pb)
Sources: Refinitiv, Bloomberg, Capital Economics; 1Fiscal years (2020 = FY19/20)
Surge in virus cases a risk to the recovery
- The economic recovery has progressed well over recent months and as things currently stand, growth is on course to be stronger than the consensus expects this year. But the recent surge in virus cases is a significant downside risk to the outlook. It is also a key reason to think that the RBI will be in no rush to withdraw policy support. We think that markets are too hawkish in pricing in rate hikes during the next 12 months.
- India’s economy has staged a remarkably strong recovery. Output rebounded to pre-pandemic levels as early as Q4 2020 and more timely indicators including our in-house mobility tracker and the PMIs point to a continued recovery since then. This year’s loosening of fiscal policy should help sustain this growth: having been a laggard throughout 2020, India now ranks closer to the middle of the EM pack for its direct fiscal response to the crisis. (See Chart 1.)
- But there are headwinds looming due to the renewed surge in COVID-19 infections – now above the peak of known cases in the first wave. (See Chart 2.) The vaccine rollout, which has picked up pace (see Chart 3), should help in time. But it won’t prevent a tightening of restrictions in response to the outbreak over the near term. If these become wide-ranging and people start to avoid public spaces again, the recovery could be derailed.
- Further ahead, the key threat is the banking sector, which entered the crisis in poor health. India’s non-performing loan ratio was already one of the highest of any EM, and it is likely to rise further now that most extraordinary measures on treatment of delinquent loans have elapsed. We think the NPL ratio could rise to a 20-year high this year. (See Chart 4.)
- In all, we think growth will be stronger than the consensus expects this year and next, but the risks are firmly on the downside.
- And even if we are right, the output gap will still be substantial at the end of our forecast horizon. (See Chart 5.)
- In these circumstances, policymakers should stay focused on doing as much as possible to support the economy. One concern in recent months has been inflation. This is set to rise in the near term, but that will be due mainly to fuel price inflation. Further ahead, a (likely) bumper winter harvest and a still-significant output gap should help to anchor prices (see Chart 6) and relieve pressure on the RBI to tighten any time soon.
- As such, we think markets are too hawkish in expecting rate hikes over the next 12-18 months, and expect the RBI to only begin normalising policy in late-2022 when the economy is closer to full health. (See Chart 7.)
- On the external sector, the current account swung into an unprecedented surplus in 2020 and, though it is likely to flip back into deficit this year, the deficit should remain small by past standards. (See Chart 8.) So even in an environment of US dollar strength, the rupee is only likely to weaken a bit with very limited macro implications.
- On the longer term outlook, the BJP at the state level has recently expedited land and labour reforms that normally face stiff political resistance, ostensibly as part of efforts to support the recovery from the COVID-19 crisis. If India does contain the virus, these moves could lay a foundation for faster growth further ahead.
Chart 1: Direct Fiscal Responses to COVID-19*
Chart 2: New Recorded COVID-19 Cases in India
Chart 3: COVID-19 Vaccines Administered
Chart 4: Non-Performing Loans
Chart 5: Real GDP (2019 = 100)
Chart 6: Consumer Prices (% y/y)
Chart 7: Repo Rate (%)
Chart 8: Current Account Balance
Sources: CEIC, Capital Economics
Surge in virus cases could hamper near-term recovery
- Economic output rebounded to pre-virus levels in Q4 2020 (see Chart 9) and the latest data suggest that it has continued rebounding in the early months of 2021. Our mobility tracker indicates that activity is close to pre-pandemic levels (see Chart 10), while the PMIs have remained very strong. (See Chart 11.) That all said, the new virus outbreak could hamper activity if it becomes more widespread and sweeping containment measures are reintroduced.
- Focusing on the expenditure side of the national accounts, government expenditure is likely to provide an important prop to activity as the Finance Ministry – finally – announced plans to significantly ramp up public spending in the Union Budget for FY21/22. The busy state election calendar means that local assemblies will keep the taps running too, at least for the first half of the year.
- It’s a more mixed outlook for household spending. It rebounded strongly in Q4 and the latest data on auto sales point to a continued recovery in Q1. (See Chart 12.) The vaccine rollout should help too. The government could on current trends surpass its target of inoculating 400m of the most vulnerable by August. (See Chart 13.)
- However, the rise in new COVID-19 cases looks increasingly likely to become a headwind in the near term. The latest outbreak has largely been limited to Maharashtra but, while still low, new virus cases have also been rising in several other large states including Tamil Nadu, Gujarat and Karnataka. If infections continue to rise unchecked over the coming days and weeks, more widespread containment measures are likely and the greater prevalence of the virus may lead to renewed social distancing by the public.
- Monthly data indicate that the impressive rebound in investment growth has lost a bit of momentum (see Chart 14) and we think the recovery will enter a slower phase from here. The government has offered loan guarantees to SMEs but many firms will remain cautious for a while yet given the renewed uncertainty over the virus situation and the fact that there is still significant spare capacity.
- What’s more, the ailing banking sector will take a further hit as more loans turn sour now that most extra-ordinary measures – such as the Supreme Court’s ban on banks classifying delinquent loans as non-performing – have been unwound. Bank lending remains very weak (see Chart 15) and further damage to balance sheets is likely to make banks even more risk averse. This will be another headwind to the investment recovery.
- Finally, the economy is likely to receive only moderate external support this year and next. Some services exports such as tourism will pick up as international travel resumes, but this will be very gradual. And we don’t expect a recovery in global GDP to substantially lift goods exports, given that they are already back to near the pre-virus path.
- Bringing all of this together, we forecast real GDP in India to grow by 13.5% in 2021 and around 8% in 2022 and 2023. Our forecasts are above consensus. (See Chart 16.) But the risks are clearly on the downside and, even if we are right, GDP would still be around 3% below its pre-virus trend at the end of 2023.
Output & Activity Charts
Chart 9: GDP (Q1 2020 = 100)
Chart 10: CE India Mobility Tracker for India
Chart 11: PMI Surveys
Chart 12: New Passenger Vehicle Sales (Volumes)
Chart 13: Number of Vaccines Administered (Millions)
Chart 14: Investment & Capital Goods Output (% y/y)
Chart 15: Private Sector Bank Credit
Chart 16: GDP (% y/y)
Sources: CEIC, RBI, Capital Economics
Returning current account deficit won’t threaten external position
- India posted a rare current account surplus in 2020, though the widening in the goods trade deficit so far this year (see Chart 17), suggests that it will be fleeting. We expect a current account deficit to return over the coming quarters.
- Admittedly, exports should receive a boost from strong global demand for vaccines, given that India is home to the world’s largest producer (the Serum Institute). But restrictions have been placed on vaccine exports to prioritise the domestic rollout. And exports more broadly are unlikely to receive a major lift even as the global recovery continues, given that they have already rebounded back to pre-virus levels. (See Chart 18.)
- Meanwhile, imports are likely to be boosted by a continued recovery in domestic demand and rising oil prices. That said, there are reasons to think the import bill will remain manageable. For a start, we expect oil prices to remain lower than their levels in the years 2010 to 2013 when India faced significant balance of payment strains. (See Chart 19.)
- And despite the recent jump, gold imports will remain lower now than in the past. The latest surge has been driven more by prices (which we think will drop back) than underlying demand. (See Chart 20.) And structurally lower rates of inflation and the availability of a wider range of financial services have reduced the attractiveness of gold for consumers over the past few years.
- What’s more, prospects for remittances – which show up in the current transfers section of the current account – into India look a lot stronger in 2021 than they did last year. The Gulf economies are getting back on their feet as oil prices recover and vaccines are rolled out. These countries are the most important source of remittances into India. (See Chart 21.)
- In all, we think the current account will tip back into a small deficit of around 1.0% of GDP in 2021, and widen further to 1.5% of GDP in 2022. (See Chart 22.)
- That would be well within the 2.0% of GDP threshold that the RBI considers sustainable, and much smaller than during the Taper Tantrum of 2013, when the deficit averaged 5% of GDP. In other words, the external risks should remain lower than it was back then.
- The composition of capital inflows adds to our belief that the external position won’t return as a source of vulnerability. Foreign direct investment – a relatively stable and long-term source of funding – rose during this pandemic and remained significantly higher than volatile portfolio inflows. (See Chart 23.) FDI inflows into most other economies fell last year.
- With the external position looking secure, we think that depreciation pressure on the rupee will remain limited, even in a world where the US dollar is likely to continue strengthening against all major currencies. We forecast the rupee to weaken only slightly to 75/$ by end-2022, from around 74/$ currently despite a dovish view on policy rates and bond yields.
- Even if the rupee sells off more, there should be limited economic fallout. The exchange rate pass through to inflation in India is very small by EM standards. What’s more, India has a very low burden of FX debt. (See Chart 24.) So the existing strains in the banking sector wouldn’t be exacerbated by currency weakness.
External Stability Charts
Chart 17: Goods Trade Balance (US$bn)
Chart 18: Seasonally-Adjusted Export Values
Chart 19: Oil Prices and Imports
Chart 20: Gold Imports
Chart 21: Largest Sources of Remittances into India
Chart 22: Current Account Balance
Chart 23: Net Capital Inflows
Chart 24: FX Debt (% of GDP, Latest)
Sources: CEIC, World Bank, Refinitiv, Capital Economics
Inflation to peak this quarter
- A rise in consumer price inflation is likely in the near term, but it will largely be driven by fuel prices. Further ahead, a (likely) bumper winter harvest and a still-large output gap should help to anchor inflation.
- CPI inflation rebounded from 4.1% y/y in January to 5.0% in February, on the back of an acceleration in both core and food inflation. A further rise is likely over the coming few months. The price of Brent crude oil is roughly twice what it was a year ago. We expect it to rise a little further this year. That could boost the headline rate by 1.0%-pts from February to June. After that however, fuel inflation should ease as last year’s rebound in prices enters the annual comparison. (See Chart 25.) It’s a similar picture for producer prices. (See Chart 26.)
- The other big determinant of headline CPI is food inflation. Daily data suggest that it rose in March but, given prospects of a bumper food harvest for rabi (winter) crops, we are optimistic that food prices will remain broadly stable over the coming months.
- High food prices in 2020 will provide a favourable base of comparison too. If prices now hold steady, food inflation will ease again before long. (See Chart 27.)
- The trajectory of food prices could also help to anchor core inflation, which has proved to be more sticky in recent months than we had expected. Most Indians spend a large share of their income on food – it accounts for nearly 50% of the CPI basket, higher than in most EMs. (See Chart 28.) One implication is that food inflation in India can influence inflation expectations, which then feed into core inflation.
- There are other reasons to think that core inflation will ease over the coming months. Our forecasts for a drop in non-oil commodity prices (such as industrial metals) should soon put downward pressure on firms’ input prices. (See Chart 29.)
- In addition, our gold price forecasts point to a further drop in personal care inflation, a component of core inflation. (See Chart 30.)
- And overarching all of this is the economic outlook. The economy has been recovering well over recent months, but output is still some way below potential. Capacity utilisation is picking up but is still low by pre-pandemic standards. (See Chart 31.) As supply disruptions caused by strict COVID-19 containment measures unwind, this should be reflected in a broad-based easing in core inflation.
- Bringing this together, we think headline inflation could soon rise above the 6% upper limit of the RBI’s inflation target. But it should peak during Q2. We don’t anticipate core and headline inflation to rise in earnest until mid-2022, when the economy should be closer to full health. (See Chart 32.)
- Of course, there is plenty of uncertainty, and the risks to inflation are skewed to the upside. For example, if the recent COVID-19 outbreak worsens, virus restrictions could be reintroduced and domestic supply chains could be disrupted yet again, which would push up prices even in the near term.
- But even in this scenario, we doubt that the RBI would respond with monetary tightening, as it would be a sign of economic weakness rather than strength.
Chart 25: Brent Crude Oil Prices & Fuel CPI (% y/y)
Chart 26: Brent Crude Oil Prices & Fuel WPI (% y/y)
Chart 27: Daily Food Prices & Food CPI (% y/y)
Chart 28: Weighting of Food in CPI Basket (%)
Chart 29: Industrial Metals Prices & Core WPI (% y/y)
Chart 30: Gold Prices and Personal Care CPI (% y/y)
Chart 31: Manufacturing Capacity Utilisation (%)
Chart 32: Consumer Prices (% y/y)
Sources: CEIC, Dept of Consumer Affairs, RBI, Capital Economics
Policymakers aim to keep borrowing costs in check
- Several EM central banks have started hiking interest rates in recent weeks and markets are pricing in tightening this year in India too. Amid rising US Treasury yields, memories of the 2013 Taper Tantrum may be playing on investors’ minds. But India is far less reliant on capital inflows than it was in 2013, and with inflation likely to remain contained, the key determinant of policy rates in the near term will be the state of the economy.
- Even if the recent surge in virus cases subsides before long, the MPC will be very wary of withdrawing policy support too soon given the still-significant output gap. We think the repo rate will remain at its record low for several quarters yet. (See Chart 33.) That should help to keep financial conditions exceptionally loose. (See Chart 34.) We only expect the RBI to begin normalising policy in late 2022, when the economy should be closer to full health.
- On fiscal policy, after dragging its heels for much of the past year, the Finance Ministry finally unleashed significant stimulus in the Union Budget for FY21/22. Demand-boosting measures in response to the pandemic are now worth 3% of GDP. That’s far smaller than in major developed economies but puts India in the middle of the pack among major EMs. (See Chart 35.)
- Importatntly, the Budget numbers also look more credible than has been the case over the past few years. Large off-balance sheet expenditures including on the Food Corporation of India have been reclassified as official spending. (See Chart 36.) The Finance Ministry has also set more realistic assumptions for revenues. Greater transparency and a lower likelihood of significant fiscal slippage compared to previous years should help anchor bond yields by reducing uncertainty.
- Even so, the wider budget deficits still means that the outlook for public debt has taken a turn for the worse. It rose to almost 90% of GDP last year, from 72% before the pandemic. (See Chart 37.) That is very high by the standards of most Asian economies. The fact that almost all of India’s public debt is denominated in rupees and held domestically means the threat of a debt crisis is low. But the authorities will still be keen to return the debt ratio to a sustainable path as soon as possible.
- One path to debt sustainability is for borrowing costs to be kept lower than the growth rate of nominal GDP, as has been the case over most of the past decade. This is another reason to think that the RBI will keep policy rates as low as possible. The central bank has also committed to purchasing more government debt on the secondart market over the coming months, which has previously helped to drive down long-term yields. (See Chart 38.)
- There are also signs of the authorities turning towards more financial repression – policies that keep borrowing costs artificially low by channelling funds to the public sector. The fact that much of the banking sector is state-owned (see Chart 39) means that these measures can be implemented without much resistance.
- One example is the use of the statutory liquidity ratio which requires banks to buy large volumes of government debt. The ratio is currently at 18%. (See Chart 40.) This could be raised back to its recent peak of 25% if borrowing costs become a concern again.
Fiscal & Monetary Policy Charts
Chart 33: Repo Rate (%)
Chart 34: CE Financial Conditions Index for India (Standard Deviation)
Chart 35: Direct Fiscal Responses to Coronavirus*
Chart 36: Central Government Funding to FCI
Chart 37: Gross Government Debt (% of GDP)
Chart 38: 10-Yr Government Bond Yield (%)
Chart 39: State-Owned Banks’ Share of Bank Assets (%)
Chart 40: Statutory Liquidity Ratio (%)
Sources: CEIC, Bloomberg, IMF, RBI, Capital Economics
COVID-19 crisis to take a toll but long-term outlook still bright
- The COVID-19 crisis will leave a legacy of impaired household, corporate and bank balance sheets that will cast a shadow over demand for years. We think that the economy will be 3-4% smaller in 2050 than it would have been had the crisis not occurred.
- There are ways in which the crisis may also affect the supply potential of the economy. For example, a damaged banking sector will weigh heavily on investment which will harm the growth of the capital stock. However, the virus has not led to destruction of productive capacity as occurs in wars or natural disasters. And the crisis will increase the incentive for firms to invest more in some areas like touchless technologies.
- What’s more, there are still a few reasons why a more positive view on India’s long-term prospects is still justified, at least relative to other EMs. The expansion of the working age population in India is set to continue. It will replace China as home to the world’s largest labour force by around 2025. (See Chart 41.)
- What’s more, Prime Minister Modi’s BJP has expedited labour market reforms that normally face stiff political resistance, ostensibly as part of efforts to support the recovery from COVID-19. These will do little to boost demand in the near term. But over time, these measures could start to deliver benefits by reducing the disincentives that hold back growth of labour-intensive firms.
- The reforms also send a positive signal of the BJP’s willingness to use its burgeoning political clout – it has the largest Lok Sabha majority since the 1980s (see Chart 42.) – to push ahead with measures that would previously have been deemed too contentious. If further labour (and land) reforms follow, that would lay the foundation for strong potential growth.
- If the government does embrace this opportunity, the long-term benefits to productivity could be substantial. India has massive scope to shift the labour force from low to high productivity sectors, and replicate the best practices of economies that have already transitioned to higher income.
- The COVID-19 crisis will cause the budget deficit to widen sharply and the public debt ratio to surge. But over the long term, public debt should drop back as a share of GDP (see Chart 43.) due to a combination of relatively strong growth in nominal GDP and policymakers keeping a lid on long-term yields through financial repression.
- The broad trend is that inflation typically falls as emerging economies converge with advanced economies. We suspect that the RBI will reduce its inflation target over time, as central banks in many wealthier EMs have done.
- India is likely to run a persistent current account deficit over the long term. That shouldn’t be a problem as long as it remains small, as it has been for the past five years. Indeed, if the deficit was the result of strong investment, that would be a positive.
- The real exchange rate is likely to continue appreciating due to relatively strong productivity gains. And given our expectations of structurally higher rates of inflation in the US over the coming years, we also think the nominal rupee exchange against the US dollar will appreciate slightly over our forecast horizon. (See Chart 44.)
Long-term Outlook Charts
Chart 41: Working Age Population (Millions)
Chart 42: Lok Sabha Election Results
Chart 43: Gross Government Debt (% of GDP)
Chart 44: Rupee vs US$
Sources: UN, CEIC, Bloomberg, Capital Economics
Key India Forecasts
Policy interest rate (%, end of period)
Ten-year government bond yield (%, end of period)
Government budget balance (% of GDP)
Gross government debt (% of GDP, end of period)
Current account (% of GDP)
Exchange rate (Rupees per USD, end of period)
Nominal GDP ($bn, end of period)
Population (millions, end of period)
Sources: UN, CEIC, Refinitiv, Bloomberg, Capital Economics