Global Insight Perspective

Significance

Gross domestic product (GDP) in real terms expanded by 9.2% on the year in the three months through September, accelerating unexpectedly from the previous quarter.

Implications

Growth continued to be driven by services and manufacturing output, responding to robust domestic and external demand. However, the growth rate underlined concerns expressed by the central bank that pockets of overheating may be emerging in the economy.

Outlook

Global Insight currently forecasts growth of 7.9% in fiscal year (FY) 2006 (ending 31 March 2007), although risks remain heavily weighted to the upside, as the economy continues to outperform expectations. The Reserve Bank of India (RBI) will continue to tighten monetary policy gradually, with a further interest rate increase expected by the end of the year.

Beating Expectations

The economy’s momentum remained relentless during the second quarter of the current fiscal year. In the three months through September, gross domestic product (GDP) in real terms expanded by 9.2% on the year, accelerating from the 8.9% rate recorded in the first quarter (April-June). Growth has stood in excess of 8.0% for six of the past seven quarters, and the economy expanded at an annual rate of 8.4% in fiscal year (FY) 2005—the fastest pace in over a decade.

Outlook and Implications

Strength in Diversity

Growth was broad-based, reflecting the economy’s diversification as its manufacturing base develops. Services expanded by 13.9% year-on-year (y/y) during the quarter, marking an acceleration from the 13.2% rate recorded in the three months through June. Financial and real estate services also posted robust growth, expanding by 9.2% y/y. Concurrently, manufacturing gained further traction, with output growth accelerating to 11.9%, from 11.3% during the previous quarter. Finally, agricultural output, on which two-thirds of household income still depends, remained positive following average monsoon rains.

The rate of production growth mirrors the current strength of demand. Exports have accelerated, as traditionally strong growth in service sectors is complemented by rising volumes of manufactured goods. In tandem, domestic demand remains robust as private consumption and investment surge, underpinned by strong credit growth. The dynamics have been reflected in the trade balance, which has recorded a widening deficit despite the pick-up in exports, as demand for consumer and capital goods intensifies.

Demand Growth Carries Risks

However, the rate of that credit growth has fanned fears that pockets of overheating may be emerging in the economy. The Reserve Bank of India (RBI) raised the repurchase rate by 25 basis points to 7.25% in October, widening the spread over the repo rate to 100 basis points. The move was aimed at containing liquidity growth in the system, which has been fuelled by buoyant foreign capital inflows (generated by remittances, portfolio investments and rising export earnings) that the domestic economy has not been able to fully absorb. The RBI estimates that the liquidity overhang in the system rose from 9.0 trillion rupees in the first quarter of the current fiscal year to 9.2 trillion rupees (US$1.2 trillion) in the three months through September, although levels are still lower than in the previous two years. Money supply growth is currently running at around 19.0-20.0%, well in excess of broad economic growth.

The high level of liquidity is fuelling rapid and potentially unstable credit growth. Non-food credit growth is currently running in excess of 30.0% in annual terms, and the funnelling of investment into certain sectors—particularly real estate—generates the risk of pockets of overheating emerging in the economy. The borrowing boom also threatens to undermine asset quality in the banking system. Housing, commercial real estate and personal loans have cumulatively accounted for over one-third of growth in non-food credit so far during FY2006. The credit-deposit ratio has deteriorated sharply, from 105.8% a year ago to 78.0%.

The strength of domestic demand, inflated by consumer and corporate borrowing, is also reflected in strengthening inflationary pressures. Although inflation has eased from the peak of 8.5% hit during the second quarter of FY2004, risks remain weighted to the upside in the rapidly expanding economy. The benchmark wholesale price index (WPI) rose by around 5.3% in annual terms during early-November, hovering near the top end of the RBI’s annual 5.0-5.5% inflation target. Some pressure may be lifted from the headline rate by the government’s decision today to reduce administered fuel prices, but demand influences remain strong, as made manifest by the strength of second-quarter growth.

Adroit Policy Management Required

Subsequently, the RBI is expected to raise interest rates again during the final quarter of the year, and maintain a tightening stance to quell the price and financial risks associated with the economy’s blistering growth. Global Insight currently projects growth of 7.9% for FY2006, although the bias for that forecast remains very much to the upside, as the economy continues to outperform expectations. Barring any unforeseen shock, it is hard to see how the current growth trend may be derailed if policy is prudently managed. Conversely, current growth rates give an indication of the economy’s huge potential, which a full and aggressively pursued reform agenda could unlock.

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