Signs of recovery in rural, urban consumption

Consumption growth has been recovering, while real estate and capex are still a drag. Within domestic demand, consumption growth has held up better than investment-related segments. In April, two-wheeler sales posted positive year-on-year (YoY) growth for the first time in six months, after registering almost no growth in the previous two months. This, alongside the continued recovery in passenger car sales growth, indicates that for the first time post demonetisation, both urban and rural consumption is improving. However, ca-pex related indicators remain relatively subdued. Real estate transactions and other capex indicators such as cement production and sales of commercial vehicles are still contracting on a YoY basis.

External demand remains supportive
Exports continued to post double-digit rates of growth for the third consecutive month, with the growth sustained across both geographies & product categories.

Headline CPI inflation moderated to 3%, due to lower food inflation:
Headline CPI inflation decelerated to 3 per cent YoY in April from 3.9 per cent in March. The key driver was food inflation, which came in at 0.6 per cent YoY, although the deceleration was led in part by base effects. To get a better indication of the underlying core inflation, the transport component and gold/silver embedded in inflation ex food and fuel is netted out. This measure of core inflation moderated slightly to 4.4 per cent in April vs. 4.5 per cent in March, with the major components remaining largely flat on a YoY basis. The wholesale price index was rebased to F2012, and as per the new index, WPI decelerated to 3.9 per cent YoY in April from 5.3 per cent YoY in March. As with CPI inflation, the key driver of the deceleration was food inflation and base effects.
Outlook and signposts
Growth acceleration from 2Q17 onwards
While growth in recent quarters has been weak, we expect growth to pick up from 2Q17 onwards. Over the next 2-3 quarters, the recovery should still be driven by consumption, public capex and external demand. In particular, the recovery in both urban and rural consumption should provide added support from 2Q17 onwards, as the impact of the currency replacement programme has waned.
A further, continued recovery in consumption and exports over the coming quarters will likely lift capacity utilisation rates. Moreover, the health of corporate balance sheets is improving, as real interest rates for the corporate sector have now fallen below real GDP growth. At the same time, more companies have had their ratings upgraded compared to the number of downgrades. The combination of these should motivate corporates to invest, and private corporate capex to GDP is expected to improve by 1Q18. By then, the economy should be undergoing a full-fledged recovery.
Implementation of GST on the near-term growth trajectory is not expected to have a significant impact. Economies that implemented GST in the past experienced a front-loading of consumption in the months prior to GST rollout. However, the front-loaded impact stemmed from rising tax rates following the implementation of the GST.
The growth impact, if any, could arise from the preparedness of the corporate sector (particularly small and medium-size enterprises) in implementing GST.
To assess the growth trajectory, it will be necessary to keep an eye on:
n Auto sales (cars, two-wheelers) to gauge the consumption recovery;
n Centre for Monitoring Indian Economy’s capex data and capital goods imports to assess public / private capex trends;
n Monthly goods exports to measure strength in external demand;
n Soft data such as corporates' commentary on GST preparedness and hard data such as industrial production and sales growth statistics.

Headline inflation to trough in June Quarter:
Favourable base effects in food inflation will persist during this period, keeping both food and headline CPI inflation somewhat on the lower side, averaging around the 3 per cent handle. Headline inflation is expected to trough in the quarter ending June, and a combination of waning favourable base effects, normalisation in food prices, and pickup in demand should lead to a pickup in headline inflation. Beyond the near term, we expect that core inflation should also edge up, driven by a recovery in aggregate demand, a rise in capacity utilisation (with exports/consumption rising), and spillover from food inflation to core inflation, which would bring headline inflation to the 5% handle by the quarter ending Dec-17.
The implementation of the GST is likely to have a minimal impact on CPI inflation. Most of the key items within the CPI basket will be taxed at a lower rate under the GST regime than they are now. The direct impact, therefore, is likely to be minimal. However, assuming that GST does have the intended effect of increasing tax compliance, the tax burden would increase, too, and could lead companies to pass the costs of increased tax compliance on to the consumer, though at a later stage (owing to increased surveillance in the initial stages in view of the anti-profiteering clause).
Hence, actual price movements need to be monitored in the run-up to and following the implementation of GST on July 1. The impact, if any, on underlying inflationary pressures is likely to be transitory.
The final impact will depend on the trends in aggregate demand and output gap following the implementation of GST.

Monetary policy response – End of the easing cycle, potential hikes in 2H18:
Incoming inflation data points have softened, dragged by lower food inflation. Against this backdrop and given the forecast of normal rainfall in the coming monsoon season and the likely minimal impact of the GST on inflation, there has been increasing debate as to whether the RBI will cut interest rates in the forthcoming meeting on June 7.
We continue to believe that the central bank is already at the end of the easing cycle. While incoming inflation data have softened, the RBI did estimate during the April policy review that CPI inflation would move lower first before rising. The softer inflation prints, in and of themselves, may therefore not alter the general trajectory of the central bank's inflation projections. Moreover, higher-frequency growth indicators are showing signs of a stronger recovery post the currency replacement program and are also consistent with the central bank's assessment. And while the projections on the impact of the monsoon and GST on CPI inflation are benign at this juncture, it might still be too early for an accurate assessment, and hence it might be better to wait for the actual effects to play out and then assess.
Moving beyond the June meeting, RBI will gradually shift its tone towards a hawkish one, eventually paving the way for a rate hike in the second half of calendar year 2018 (2H18). This is predicated on the view that the economy evolves according to our base case and also the RBI’s narrative that growth recovers further and inflation picks up as food prices normalise. The key factors underpinning this shift are that the economy will likely be undergoing a full-fledged recovery with domestic private capex picking up by 1Q18 and also against the external backdrop that the US Federal Reserve will be taking its interest rates higher over the forecast horizon.

Focus to remain on fiscal conso-lidation & produ-ctivity enhancing reforms:
Overall, the government will maintain its policy stance of pursuing fiscal deficit consolidation and efforts to revive private capex and the productivity-enhancing policy reform process. While the central government's deficit has been declining, the states' deficits have been rising since FY2013. These increases have taken place even though states' share in government revenue has risen post the 14th Finance Commission recommendations. The rising trend in states' fiscal deficits has in some ways offset the improvement in the central government deficit, keeping the consolidated fiscal deficit high
at around 6.5-7 per cent
of GDP. On the reforms agenda, the GST council has reiterated that GST will be rolled out on July 1, and in recent weeks,
there has been a renewed policy focus on job
creation, given the
sluggish job growth trends.
Source: MorganStanley Research