India: Soft Landing in 2008, Recovery in 2009

Clear signs of a slowdown in growth have emerged over the past few months. In a recent survey of 319 chief operating officers and managing directors by the Associated Chambers of Commerce and Industry, 79% of respondents felt that conditions in the Indian economy were poised for a slowdown. Tightening measures by the Reserve Bank of India (RBI) have lifted the mortgage and consumer borrowing rates by about 400 bps from the bottom. Mortgage lending rates are now closer to peak 2001 levels. In addition to monetary tightening, the central bank has shifted its exchange rate management approach since early March, allowing faster appreciation of the currency. The rupee has appreciated about 11.4% against the US dollar since early March. Indeed, this appreciation has been much higher than that by other regional currencies. The combined effect of these two measures, and a slowdown in export demand from the developed world, has resulted in weaker domestic and external demand growth.

More importantly, overheating concerns have been declining. Over the past few weeks, headline inflation has moderated well below the RBI’s comfort zone. The more widely followed wholesale price index slowed to 3% during the week ended November 24, 2007, from the peak of 6.7% during the week ended January 27, 2007. The inflation-based consumer price index (industrial workers) moderated to 5.5% in October 2007 from the peak of 7.9% in June 2006. Inflation, excluding food and global commodity-linked products (core inflation), decelerated to 4.6% for the week ended November 24 from the peak of 6.5% (average) in April 2007.

Property purchase transactions have declined significantly, with price declines evident in some areas. In 3Q07, mortgage disbursement by the three largest mortgage lenders in India – ICICI Bank, HDFC, and LIC Housing – was up just 3% YoY, further reflecting weakening property demand. These three lending companies combined account for about 42% of the all-India mortgage loan portfolio. The current account deficit (excluding remittances), though high, has stabilized at around 4%. Credit growth moderated to 23.3% in the fortnight ending November 23, 2007, from the peak of 33.1% in June 2006.

Slowing consumption, strong capex improving underlying demand-supply imbalance. The RBI’s policy measures have successfully engineered a soft landing in the growth cycle. More importantly, we believe these measures should gradually improve the demand-supply imbalance, which was at the heart of recent overheating of the economy. While consumption spending has significantly moderated, investment growth has remained strong. The interest-rate-sensitive segments, such as automobiles and consumer durables, have reported an extremely weak trend over the past two quarters. However, growth in capital goods production has remained steadily high. Although a higher cost of capital and slowing consumption demand will result in some moderation of capex growth, we expect it to remain relatively high.

No immediate official rate cut but effective monetary policy easing to continue. We do not expect a policy rate cut in the near term. First, while investment growth has picked up, a long gestation period, particularly for infrastructure, implies that effective supply (commissioning) of new capabilities will take a long time. Therefore, we believe the RBI would like to keep aggregate demand growth at current moderated levels before it reverses its monetary policy stance. Second, the RBI remains concerned about higher global oil prices and food prices weighing on inflationary expectations. Morgan Stanley oil and gas analyst, Vinay Jaising, estimates that if international crude prices remain unchanged, the oil subsidy burden will rise to 1.8% of GDP during 2008. The longer oil prices stay at current levels, the higher the pressure on the government to hike domestic fuel prices. Similarly, while international food price inflation has moderated recently, the absolute levels remain elevated. We believe the RBI would prefer to see a meaningful correction in international oil and food prices before officially signing off on a loosening of monetary policy. Meanwhile, market forces will ensure that banks continue to pursue a moderate reduction in lending rates. This will be inevitable, as credit growth is now lower than deposit growth, resulting in a fall in the credit-deposit ratio. We maintain our view for lending rates to fall 75 bps by March 2008.

Recovery in 2009. We expect growth to recover to 7.8% in 2009, driven by an improved global environment and a gradual improvement in supply response, particularly for infrastructure, allowing policy makers to pursue a more constructive monetary policy. The key risk to our view is a deeper recession in US and prolonged risk aversion in global financial markets.

By Chetan Ahya Singapore
Morgan Stanley
December 17, 2007