The Indian economy is doing very nicely indeed at present. But it could be flying into headwinds.

It’s nice to be Number One. That’s the spot India has been occupying recently. Its year-on-year GDP growth hit 8.2% between April and June 2018, or, as Indians would put it, in the first quarter of fiscal 2019 (Q1 FY2019). The following quarter’s growth disappointed a little, at 7.1%. But that still left it as the world’s fast-est-growing major economy, ahead of its long-time rival China, whose growth has slowed down.

Will it last? Well, yes and no. Yes, in that the Indian economy will very probably continue to grow at a very brisk rate for at least another couple of years. No, in that said rate is unlikely to be anywhere near 8.2%. Something a shade over 7% is most likely for the next few quarters.

That, incidentally, puts us in the comforting company of the IMF about FY2019 growth: after the brisk start to the year, one quarter of 7.1% and two of 7% y/y growth would mean an overall annual growth of a little more than the 7.3% predicted by the Fund in its latest World Economic Outlook, published in October 2018. But it means we are rather less optimistic about FY2020: the IMF predicts 7.4%, but we are saying 7% or a fraction higher.

Maybe that 8.2% figure should have surprised the pundits less: it came on top of unusually low growth of 5.6% in the cor-responding quarter of FY2018, meaning a low-base effect. But general briskness – compared with a dip in growth to 6.7% in FY2018 as a whole – is no surprise either. The economy has been recovering from recent temporary disruptions - the sudden withdrawal of cash in the traumatic “demonetisation” in November and the introduction of a General Sales Tax (GST) in mid-2017 – and is reverting to form.

And there’s good reason to suppose growth will continue to be respectably high. Several factors favour this. There’s the supply-side impact of ongoing structural reforms. Private consumption is expected to prove fairly resilient. Substantial public investment will go on sup-porting infrastructure growth. And government coffers will continue to benefit from the higher tax-take resulting from the GST following the initial disruption.  

Why growth won't be faster

But why not faster? For an array of reasons. One set of reasons is political. Economic reform momentum is likely to slow ahead of the general elections due in 2019 and Indian stock markets are expected to re-main volatile, which will restrain private investments and overall economic activity. Further, even though the current ruling party – the reformist and Hindu nationalist Bharatiya Janata Party (BJP) of prime minister Narendra Modi – will probably emerge from that election as the largest single party, there is little chance that it will win an outright majority.

If it doesn’t, that would either mean a minority government in New Delhi or the return of coalition government. Either would probably dampen the prospects of a more determined push to economic re-forms, in fields including land, labour, and banking, among others. And that would be likely to sap both business sentiment and consumer confidence in the coming fiscal year.

No private investment surge

But there’s more. What’s needed for economic growth very much above 7% to happen is a broad-based and sustained private investment recovery. And that’s unlikely in the next couple of years, for a variety of reasons.
For a start, Indian firms are suffering from high leverage and excess capacity. Already under pressure from high borrowing costs, they are expecting higher lending rates. The rupee depreciated markedly this year, amid increasing uncertainty, and shows no signs of stopping: that has made it more expensive for Indian firms to borrow on global markets – and has made dollar-denominated loans costlier for them too. And on top of all that, the banking sector, stressed by a bad loan portfolio that has topped INR 10tn, is already reluctant to lend to firms.

All that means that firms are likely to be more reluctant to announce new investment projects in the run-up to the elections – and maybe even after them. So private investment growth, far from surging, will probably slow down in the rest of FY2019 and for the whole of FY2020 – possibly to single figures in y/y terms. Which isn’t what the doctor ordered.

Those fears of higher interest rates may be quite well-founded, incidentally. India’s central bank, the RBI, hiked its key policy rate in August 2018 from 6.25% to 6.5% – its highest in two years – to tackle inflationary pressures and shore up a depreciating rupee (whose value proceeded to fall briefly below the INR 74:USD 1 mark in early October). The RBI decided to keep the policy rate stable on December 5, 2018. How long that will last is another matter. The bank also noted that it was “maintaining a stance of calibrated tightening”. The shock resignation of RBI Governor Urjit Pa-tel on December 11 spooked forex markets, and may reflect serious tensions between central bank and government. Potentially,moreover, the RBI isn’t short of risks to worry about.

Reasons to be fearful

One is inflation. Now, inflation in the country is at present still within the RBI’s comfort zone – as represented by its medium term target of 4%, plus or minus 2 pp. That’s defined in terms of retail inflation (CPI without exclusions), an indicator that has come down very nicely, from 4.92% in June 2018 to 3.31% in October. That was mainly on the strength of unexpected drops in food prices, which will presumably be compounded by a sharp oil price decline since October. However, there’s still the possibility of sustained and broad-based upward pressure on core inflation, while the recent relaxation of retail pricing rules means that firms will be able to pass input costs on to customers to a greater extent.

The international environment is worrying, too. For various reasons, India looks as if it might be threatened by a widening current account deficit. Admittedly, the fact that the rupee has weakened so much could provide some boost to exports for several quarters to come. But there’s US monetary policy tightening to reckon with. There’s also the possibility that the US-China trade disputes will escalate rather than move towards a settlement, that market and currency volatility will increase, that there will be greater capital outflows from emerging economies, and that trade protectionism will rise globally. If some or all of that happens, it would lead to slower growth in the economies of India’s main trading partners. And that, in turn, would probably result in lower demand for Indian exports.

The oil price fall has, for now, lessened but not removed the balance of payments threat. And a widening current account deficit would mean further INR depreciation against the USD, heightened uncertainty, reduced domestic demand, impaired business confidence, increased currency volatility, and capital outflows. Those outflows have already been happening, indeed: foreign institutional investors sold significant amounts of Indian equity in 2018, as they fretted over high oil prices and INR depreciation. So the RBI will want to attract portfolio investments in both debt and equity markets. Which, incidentally, points to higher interest rates as well.

So, there are a number of possible head-winds to growth for the high-flying Indian economy. All this said, what is particularly disconcerting about them is that a combination of them is likely to make the economic environment more uncertain and financial markets more volatile. That means maintaining economic stability will probably be rather more challenging for policy makers in the remainder of FY2019 and FY2020. That is especially true because high oil prices, rising interest rates and higher government bond yields (among other factors) will increasingly restrict the already limited fiscal policy space to counter such challenges. 

In other words, it’s quite possible that a growing current account deficit will feed into a rising fiscal deficit and that a more uncertain global trade environment, coupled with structural constraints, will limit the benefits a weakening INR will have on exports. Narendra Modi has more than elections to worry about.