In their latest note, Morgan Stanley has revised upwards their Indian economy growth estimates for 2013, 2014 as well as 2015. At the same time, it is cautiously optimistic about Indian economy prospects

Morgan Stanley believes that the Indian economy will be able to achieve 6% growth by 2015 from the current stagflation-type economic environment. It has revised and raised its Indian economy growth expectations for this year end as well as 2014, to 4.7% and 5.1% (India’s GDP grew at 4.8% as per data released on 29^th November.) The note said, “We are lifting our 2013 and 2014 GDP growth estimates to 4.7% and 5.1%, respectively, from 4.4% and 4.6%.” It has revised its updates based on the following factors: delay in QE taper, improving the external funding environment; short-term policy fixes in the form of aggressive control on gold imports and FX swap-related dollar flows; better than expected export growth; and better than expected farm output.
 

The bullish and bearish scenarios
 

Morgan Stanley has plotted three outcomes for the Indian economy: bullish scenario, base scenario and bearish scenario. In the bullish scenario, it believes India will grow at 6% by 2014, while in the bearish scenario it believes that the Indian economy will grow at 4.2% by 2014. The below chart depicts their expectations.

What India must do to overcome challenges?

When it comes to forecasting, Morgan Stanley is cautiously optimistic and believes that 2014 would be the year of “adjustment” for the Indian economy, or the year at which the Indian economy will recover, provided certain challenges are overcome, and will also hinge on the outcome of the 2014 Indian elections. According to Morgan Stanley India must do three things:

1. Address inflation
2. Reduce fiscal and current account deficit (CAR)
3. Clean up the balance sheet of the banking sector

However, to achieve all these collectively require the government as well as regulators like Reserve Bank of India (RBI) to initiate several policy actions and reforms, particularly increasing Indian household savings.
 

The note said, “The government sector will need to continue to be on a path of fiscal consolidation, ensure that rural wage growth do not spike up, and boost growth via policy reforms that will help to improve investment. These measures will help to improve productivity growth and moderate inflation pressures. At the same time, the central bank will also need to manage real rates in a way that incentivises households (savers) to increase their allocation towards financial saving (deposits) and away from gold. As deposit growth is lifted, liquidity for the banking sector (as measured by loan-deposit ratio) will also improve simultaneously, which can then be transmitted towards lower interest rates for the corporate sector.”
 

High inflation hurting, savers flocking to riskier assets: gold and real estate
 

High inflation has eaten retail investors savings, thus discouraging households from keeping money in bank fixed deposits and savings account (aka cash), and instead are moving to more risky instruments such as gold and properties. The note states, “High CPI inflation has kept real interest rates negative since the credit crisis, encouraging households to reduce financial savings and increase allocation to gold and real estate.” This has put a dent to the CAR. However, Morgan Stanley also expects inflation to moderate a bit. It says, “In our base case, we expect CPI inflation to finally decelerate to 7% in a sustained manner by December 2014 after five years of average inflation of 10%.”

Morgan Stanley states that one of the most important things the government must do is to encourage household savings. The note states, “Adjustment of the fiscal deficit and resultant deceleration in CPI inflation is critical to allow for increase in public saving and increase in household financial saving (deposits).”

RBI desperate measures to reduce CAR

In order to beef up household savings and prevent further deterioration in CAR, the government imposed controls on gold imports and increased dollar inflows via FX swaps (and thereby restricting rupee downfall. Morgan Stanley says, “These two near-term policy fixes will improve India’s balance of payments position by a combined US$50-55bn, thereby reducing the external pressures in the near term,” and “alleviate upward pressure on short rates.”

Banks in trouble
 

Since household savings is low, banks have had to rely on other sources to augment its deposit base. Moreover, banks are to blame as well. Their reckless lending has led to impairment of loans. The double-whammy of poor deposit growth and high credit growth has put further stress on bank balance sheets. As per Morgan Stanley, public sector banks impairment of loans stood at 10%. Public sector banks will have to slow down and lend less or else be recapitalised to stimulate growth without a slowdown. The note said, “We believe that as public sector banks provision fully for the underlying non-performing loans, their ability and willingness to lend for new investment will be constrained unless the government takes up a quick recap of their balance sheets.”

Moneylife had predicted this mess last year itself, in July, that this would snowball to a major issue. You can read the Cover Story here. With the banking system in trouble, Morgan Stanley expects capex, which depends on credit, to slow down and remain constrained within the next 12 months.
 

Exports the key to growth turnaround
 

Apart from controlling inflation, exports will be a key to bridging the CAR divide and GDO growth. Because domestic demand will be restrained viz low spending, low savings and such, the external sector becomes a catalyst. Morgan Stanley says, “The key factor that will influence the growth outlook in the near term will be external demand.” They also say, “We expect services exports to follow the trajectory of goods exports, showing recovery in the next six months. In this context we expect external demand to provide support to slight recovery in overall growth over the next three quarters.”

However, in order for this to happen, Morgan Stanley believes that the government must do two things to improve productivity:

1. Reverse distortions in land, labour, and capital prices
2. Change the expectations about the returns on investment for entrepreneurs by systematically addressing the issues related to the business environment