 "Growth indices suggest two-speed recovery is narrowing")
Growth slowed in the first quarter of FY17 and monthly industrial production and export numbers continued to reflect the ongoing weakness, even into the second quarter (Q2). Is the economy really recovering and, if so, how fast? The discrepancy between the two GDP (gross domestic product) measures - GDP at market prices and the gross value added - and their apparent disconnect with ground-level data compounds the confusion over the true pace of growth. A few weeks ago, the Reserve Bank of India (RBI) surprised markets by cutting rates and lowering the real rate target. Even in an inflation-targeting framework, predicting monetary policy remains as complex as ever. To bridge some of these gaps, Nomura has created a set of proprietary indicators that help answer five critical questions on the direction of economic data and the near-term monetary policy path.
First, is the pace of economic growth above 7%?
The monthly activity indicator presents the weighted-average growth of 19 high-frequency indicators such as railways and aviation traffic (passenger and cargo), production of steel, cement, cars and two-wheelers, diesel consumption and cellular subscribers, among others. This indicator shows that, since November 2014, India's non-agriculture growth momentum has slowed. From 9.3 per cent in the second half of 2014, the monthly activity indicator has fallen to 6.8 per cent in the second quarter of 2016 and further to 5.5 per cent in August 2016. Although these numbers are not directly comparable to GDP figures, they provide an alternative measure for the direction of the recovery.
Second, which sectors of the economy are picking up?
While private-sector investments were weighed down by the weak global backdrop, excess spare capacity and high leverage, government capex also started off rather slowly this year, gaining traction only in August (when it rose 240 per cent year-on-year (y-o-y) after a 17 per cent fall during April-July). In services, we see a divergence between financial services (languishing) and non-financial services (robust). More recently, slowing sales of light, medium and heavy commercial vehicles suggest the sluggishness in industry is starting to feed into transportation services.
Our heat-map of 32 economic indicators, which provide a bird's-eye view of the drivers of non-agricultural GDP growth, shows a two-speed recovery characterised by a divergence between consumption and investments on the demand side, and services and industry on the supply side. Moreover, with industry starting to weigh on transportation services, a key engine of growth so far, the foundation of the ongoing recovery seems to be narrowing. The uneven performance across drivers and between sectors is weighing on the pace of the overall recovery.
Third, where is the economy headed?
In the absence of any new growth impulses, non-agricultural GDP growth - which slowed to 8.2 per cent y-o-y in the first quarter of FY17 from 8.4 per cent in the fourth quarter of FY16 - should decelerate further in coming quarters. Nomura's composite leading index, which leads non-agriculture GDP growth by two quarters, shows that weak industrial growth, the lagged impact of tighter liquidity prior to April, slowing credit growth (high non-performing assets, highly leveraged firms, lack of private investments) and waning terms-of-trade gains will likely slow non-agricultural growth in Q2 and Q3 of FY17. However, the upcoming boost from the Pay Commission recommendations and monsoons, not captured in the index, could provide some cushion and help stall this slowdown.
Fourth, what will RBI do?
There are several global and domestic factors that form key inputs into RBI's policy decisions. Even at the October policy meeting, the RBI governor highlighted the implications of weak global backdrop and falling global neutral rates on India's monetary policy. To assess the likelihood of monetary easing versus tightening in the near term, we look at the Nomura RBI Policy Signal Index (NRPSI), which incorporates the impact of the latest trends in growth and inflation, as well as both external (Fed funds rate, oil prices, exports, global growth) and financial (exchange rates) indicators on monetary policy. NRPSI, which accurately signalled the 50-basis point (bp) rate cut in September 2015 and the 25-bp rate cut in April 2016, has been in the neutral zone since June 2016. It suggests that currently, economic data do not warrant further rate cuts.
Fifth, what is more likely - a positive or negative data surprise?
Since May 2016, there has been a string of negative data surprises, with inflation edging higher and industrial production and GDP growth disappointing. However, these negative surprises have gradually waned, partly as consensus views have adapted by moving lower after past disappointments. Nomura's Economic Surprise Index (NESI) looks at such surprises in key economic data releases relative to the consensus views. More recently, NESI has turned marginally positive as retail inflation and PMI beat consensus expectations. We expect this positive trend to continue.
The bottom line
Overall, our growth indices suggest the ongoing two-speed recovery is narrowing, and our leading indicators indicate a slowdown in non-agricultural growth in Q2 and Q3 of FY17. While good monsoons, public-sector pay hikes, and continued public capex will provide some impetus to growth, their impacts will be mostly back-loaded in the financial year and, therefore, we expect real GDP (market prices) growth to moderate to 7.4 per cent y-o-y in FY17 from 7.6 per cent in FY16. On monetary policy, our proprietary indicator shows that, based on economic data, further rate cuts are not warranted. However, given the new RBI governor's tolerance for higher inflation and the lowering of the neutral real rate target, we believe RBI will be opportunistic and cut the policy rate by 25 basis points in February.
(Sonal Varma is Nomura's Chief India Economist and Neha Saraf is an India Economist)
