India slowdown, high inflation likely to persist

This is causing confidence in the growth story to wane while worries rise. Indian stocks, hit by inflation and high interest rates, are Asia's worst performers this year-- down nearly 14 percent -- resulting in a decline in portfolio flows. Weaker tax revenue can widen a yawning fiscal deficit.

Also, there's a possibility that India could lose out to China and smaller Asian economies in the battle to attract big foreign investment. China has cooled as it, too, battles inflation, but still might grow 10 percent this year.

Several years ago, annual Indian growth was about 9.5 percent. Then it fell to 6.8 percent during the global financial crisis but recovered to 8.5 percent in the last fiscal year, which ended March 31.

For the current fiscal year, private economists are slashing growth forecasts to below 8 percent and notching up inflation projections. In May, annual inflation was 9.06 percent -- compared with 5.5 percent in China.

Lower growth is an unavoidable result of the Reserve Bank of India's fight against inflation, which has featured 10 increases in interest rates since March 2010.

"It's going to be a difficult year," said Vishnu Varathan of Capital Economics.

Growth is likely to be less than 8 percent and will not pick up rapidly "especially with policy having to choose between price stability and growth," he said.

The government was hoping growth in gross domestic product, which was 8.5 percent in the year ended March 2011, could remain as high -- but it cannot, given the battle against inflation and other factors including weak political leadership. Credit Suisse forecasts growth will be just 7.5 percent this fiscal year and the following one.

"We are only at the early stages of seeing the impact of the monetary tightening, the negative effects of which are likely to persist well into 2012/13," it said in a note this month.

In its latest move, the central bank on June 16 raised to 7.5 percent the rate at which it lends to banks.

Even after 10 increases, India's real interest rates remain negative, meaning the inflation pace remains above rates. That can drive consumption at a time the government is not succeeding in boosting supply, so inflation can be further fuelled, resulting in further tightening and economic pain.

"Inflation is entrenched in India, and now mostly reflects demand side pressures," said Frederic Neumann, managing director and co-head of Asian economics research at HSBC.

A slowing economy cuts tax revenue, widening the fiscal deficit. High oil prices have cut demand, swelled import bills and raised costs at corporates. Meantime, the global picture looks discouraging, clouding the outlook for exports -- which have been a bright spot.

India escaped the worst of the 2008 global downturn due to robust internal demand and high government spending. A large middle class flush with cash spent on everything from gold to cars, and factory capacity got pushed to limits. But then firms dithered on adding capacity, thanks to weak global recovery and domestic policy uncertainty amid a slew of corruption scandals.

Price pressures were emerging too. New Delhi's easy fiscal policy to cope with the global slowdown was not rolled back quickly enough and the central bank was widely seen as behind the curve. Drought in 2009 made caused food prices to spike.

But no one expected the level of India's slowdown in the January-March quarter. For the first time in five quarters, annual growth was below 8 percent. Growth in private investment slumped to 0.4 percent from 7.8 percent a quarter earlier, while annual gains in consumption demand slowed to 8 percent from 8.6 percent.

Industrial output has risen in single digits the past six months. Car sales, a barometer of consumer demand, have slowed with May's total rising the least in two years. Manufacturing data show that firms' input costs have been rising faster than output costs since December.

"It looks like the manufacturing sector is going to see very subdued single digit growth. Continued interest rate hikes are going to hamper sustained high growth in consumer durables," said Varathan of Capital Economics.

"Robust growth in export is the only positive factor for manufacturing sector. But that will help only selective industries."

Exports posted record growth in the year ended in March. India exported $245.9 billion of goods during the year, far above the government's target of $200 billion.

A slowdown is evident in services, which account for about 58 percent of the economy. The sector has slipped twice in the last three months, with May's expansion being the slowest in 20 months.

The sector is grappling with higher costs. Aon Hewitt estimates Indian companies will have to pay 13 percent more to employees in 2011.

"Slowing manufacturing activity, rising input costs, tight liquidity, interest rate pressure and a government looking to tighten its fiscal belt don't make a very rosy outlook for the services sector," said Siddhartha Sanyal, an economist with Barclays Capital in Mumbai. He expects GDP growth of 7.7 percent in 2011/12.

The farm sector is expected to defy the slowdown on the forecast of a normal monsoon. It grew 6.6 percent in 2010/11, compared with 0.4 percent a year earlier.

A good harvest should help shore up rural demand, which should save the economy from any severe slowdown. But to what extent higher rural income can offset a slowdown in consumer spending is unclear.

The government is looking to keep a lid on spending to meet its fiscal deficit target of 4.6 percent for this fiscal year.

Policy inertia in the wake of graft scandals is not helping the economy. The government is repeatedly deferring decisions on raising prices of diesel, kerosene and cooking gas, even as high global prices threaten its fiscal gap target.

Lack of policy as well as regulatory hurdles have held up investment in infrastructure and retail sectors. In 2010/11, India received 25 percent less foreign direct investment than the previous year.

"The near-term economic outlook will continue to be affected by the lack of positive policy activism on reforms, paralysis in decision-making, and ongoing fear about the unfolding corruption issues and investigations that have affected business confidence," said Rajeev Malik of CLSA.