India GDP. How will the economy pan out this fiscal?

The second wave of Covid-19 has made 2021 worse than 2020. The year began with almost normal economic activity, only to be marred by the resurgence of Covid infections beginning February 2021. Although it was initially largely concentrated in Maharashtra, it has spread quickly through the entire country.

One major difference in 2021 vis-à-vis 2020 is the reluctance of the Central Government to announce a national lockdown (called ‘sudden stop’ in economics parlance). This is one of the most important lessons learnt from the 2020 experience. With no major economic support, not everybody has the option to choose between life and livelihood.

Instead, this time, more regional restrictions have been announced, with some States resorting to complete lockdowns recently. Consequently, while the economic activity has certainly seen a drop, it is nowhere as worse as 2020.

With real GDP estimated to have contracted 8 per cent in FY21 (the worst fall since Independence), the base effect makes FY22 look extremely strong with the Reserve Bank of India projecting a real GDP growth of 10.5 per cent. It implies that real GDP in FY22 will be just 2 per cent higher than in FY20.

This forecast, however, is unlikely to have incorporated the downside bias imparted by the second wave of Covid-19. And therefore, the double-digit growth may turn out to be elusive. At 8.3 per cent growth, real GDP in FY22 will be equal to the FY20 level. Increasingly, it appears that real GDP in FY22 may stay lower than in FY20.

Inflation trajectory

What is more surprising, however, is the renewed narrative on India’s inflation trajectory. It is now believed that both headline and core inflation seem to be driven by supply-side economics, rather than demand. Accordingly, it is argued that, notwithstanding demand destruction, inflation will rise if economic restrictions — leading to supply constraints — sustain due to the second wave.

This narrative is largely driven by the experience of the Indian economy in 2020. Just a year ago, economists were more traditional in their approach and expected inflation to weaken due to one of the strictest and prolonged national lockdowns. Nevertheless, when the imputed estimates were published for April-May 2020 along with June estimates on July 13, 2020, an average inflation of 6.6 per cent YoY in the first quarter of FY21 (April-June) came as a surprise.

India is one of the very few nations which saw higher inflation last year. Although inflation rose in many developing economies initially, it cooled off quickly as economies opened up and fell significantly below the target/desired level. In contrast, while the headline inflation in India topped at a 77-month high of 7.6 per cent YoY in October 2020, the core inflation continued to inch upwards to hit a 29-month high of 5.7 per cent YoY in March 2021. Headline inflation touched 4.1 per cent (a tad above the medium-term target) in January 2021 and averaged 6.2 per cent (higher than the target ceiling of 6 per cent) in FY21. Inflation, in other words, never fell below the medium-term target of 4 per cent in India during the worst year since the 1950s, let alone touching the floor of the target (at 2 per cent).

However, one tends to differ from this renewed narrative. Higher inflation in India in CY20 was more to do with the excessive rent-seeking behaviour of the producers and the government’s decision to raise taxes on fuel commodities. The former was true for essential items such as food, personal care (with or without gold) and transport & communication (excluding retail fuel), which actually witnessed higher demand during lockdowns and supply disruption was relatively lower.

Excluding these essential components, inflation in the non-essential basket (with weight of 42 per cent) was 3.8 per cent in FY21, same as in FY20. Accordingly, inflation doesn’t seem to be a supply-side problem in India. For FY22, it is likely to average around 4.7 per cent, with upside risks.

Therefore, the RBI may find it difficult to ease monetary policy further. Also, as far as fiscal policy is concerned, it appears that the Central Government may continue to follow a “hands-off” approach, unless things deteriorate substantially.

Household finances

Our analysis suggests that unlike in many other economies, the major burden of income losses in India fell on the household sector, since fiscal stimulus was limited in CY20.

With no major fiscal support even this time, household finances will weaken further, raising serious doubts over the strength of the recovery, as and when it happens.

The recent monetary policy indicates the RBI has positioned itself to support the bond market, assuming foreign capital inflows (and, thus, balance of payments surplus) will be more contained in FY22. As against the BoP surplus of $60 billion in FY20 and about $100 billion in FY21, the surplus could fall to $40 billion this year.

Unless foreign capital inflows surge more than expected, the RBI’s position is broadly in line with the need of the hour. Hopefully, the rest of 2021 will be much better than 2020.

The writer is Economist, Motilal Oswal Financial Services Ltd

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