Morgan Stanley - India: Beyond the Cyclical Boom

Unusually strong growth cycle. India has achieved strong economic growth of 8.2% over the past three years versus 6.2% in the preceding ten years. This compares with average economic growth of 10.3% for China and 5.3% for Emerging ASEAN countries in the past three years. Although we believe that some acceleration is warranted due to structural factors, the greater part of growth has been a result of the sharp rise in capital flows in response to an increase in the global risk appetite. The global liquidity spillover into India has allowed the government to pursue relatively loose monetary and fiscal policies, which have supported the acceleration in cyclical growth.

Structural story – an interplay of three macro factors. The interplay of three key macro factors – demographics, reforms and globalization – justifies a gradual speeding up in India’s pace of growth. India’s age dependency has fallen (the share of the working population in the total has risen), from 64% in 2000 to 59.6% in 2005, and is likely to continue to drop, to 55% by 2010 (according to United Nations’ forecasts). The government’s implementation of gradual but progressive reforms has improved the utilization of the working-age population, a key resource. Finally, a backdrop of strong globalization has enabled growth in job opportunities to accelerate. India’s exports are expected to rise to 21% of GDP as of 2006 from 12.6% as of 2000 (based on our estimates).

Cyclical story – facilitated by low global real rates. We believe that India has witnessed an unusually loose monetary policy over the past few years. The genesis of this has been the large capital inflows into India (and emerging markets in general). Cumulatively, over the past three years India has received capital flows of US$72 billion versus US$28 billion in the preceding three years. Low real interest rates globally and the consequent rise in risk appetite have driven this disproportionate increase in capital inflows into India.

With a weak supply-side response, India’s absorption of liquidity for investment has been less than optimal, resulting in excess liquidity. Over the past five years, households and the government have lapped up this liquidity, increasing India’s debt-to-GDP ratio by 26 percentage points, which has supported the acceleration in GDP growth. This compares with increases in the debt-to-GDP ratios of the US and China of 25 and 8 percentage points, respectively, during this period. This debt has, in turn, been used either to bolster consumption or to fuel asset prices, and has boosted growth beyond sustainable levels, in our view.

Persistent acceleration in growth raises risk of sharp contraction. If the growth acceleration trend is sustained by household and government borrowing at a time when corporate credit demand remains strong on account of capital spending, this could raise the risk of a steeper deceleration in growth. A trigger could be one of the following macro challenges:

Inflation pressure:With domestic demand (as reflected in strong credit growth) remaining strong, the central bank, the Reserve Bank of India (RBI), has been especially concerned about potential inflationary pressure. Headline wholesale price inflation (WPI) has reaccelerated to 5.3%, close to the RBI’s maximum tolerance level of 5-5.5%. Indeed, we believe the pressure on headline WPI will intensify as a result of increases in global commodity prices (other than oil) in the past few months.

Current account deficit:We have argued for a while that, in an open economy, if aggregate demand is higher than supply (reflecting a slower pace of domestic capacity creation), this contributes to a current account deficit as well as inflation. The current account balance turned to a deficit of US$6.1 billion (3% of GDP, annualized) during the quarter ended (QE) June 2006 from a surplus of US$1.8 billion in QE March 2006, driven by an all-time high trade deficit.

Stretched banking sector balance sheet:The gap between credit and deposit growth has been a key concern. Although credit growth has currently moderated to 29% from the peak of 33% in June 2006, it remains significantly higher than deposit growth of 21%. The trailing one-year incremental credit-deposit ratio is also very high, at over 90%. With the banking sector’s holding of government-approved securities (largely government bonds) already at 29.6% (close to the statutory minimum of 25%), there is little scope for banks to continue with the current high credit disbursement rate.

Credit quality: In addition to the strong growth in credit, the quality of credit being disbursed is causing concern. Banks have not only been lending more to riskier segments but have also been mis-pricing the credit. The RBI is clearly worried about the strong credit growth in the retail and real estate sectors. Although the RBI has initiated administrative measures to reduce the bias towards funding consumption and less productive sectors, there has not been a meaningful correction in this trend so far.

Property market euphoria:As discussed above, excess liquidity without an adequate supply response in the form of absorption of investments is resulting in higher asset prices. For property, the less supportive regulatory framework and the government’s inadequate and slow response to the need to create urban infrastructure have resulted in weak growth in property supply. As a consequence, property prices have risen by 100-300% in major cities in the past two years.

Global developments and re-pricing of risk:We believe the loose monetary and fiscal policies have supported a large increase in debt to GDP, which in turn has contributed to a spike in growth rates above sustainable levels. This rise in debt to GDP, without a commensurate increase in market-driven interest rates, has been due to large inflows of foreign capital, particularly portfolio equity flows (driven by a growing global risk appetite). Without these large capital inflows, real interest rates would have been higher and growth rates lower. We believe that any slowdown (not necessarily outflow) in capital inflows due to a change in the global environment could result in a disruptive rise in interest rates.

Our base-case forecast remains a soft landing. We expect growth to soft-land over the next four quarters to around 7%, driven by the lagged impact on credit growth of higher real rates and the central bank’s administrative measures. In the event of growth surprising on the upside, we think the risks of a sharp spike up in the cost of capital and an aggressive landing of the growth cycle would rise sharply. In our view, the government needs to implement measures to stimulate the supply-side response by investing in infrastructure, implementing labor reforms, improving the management of government finances and strengthening the administrative framework