The Indian government has set a target to reduce their budget deficit from 4.8% of GDP in fiscal year 2010/2011 to 3.7% in 2016/2017. The official deficit for 2011/2012 was 4.6% of GDP but the deficit increased beyond what was expected and reached around 5.3% of GDP in 2011. This tightens the government’s capacity to use fiscal stimuli to boost economic growth amid decelerating rates of growth. On the monetary policy front, the Indian central bank (RBI) has been reluctant to reduce its policy rates to curb inflationary pressures. There have been 13 increases in the repurchase (repo) rate (the interest rate at which the RBI supplies funds to the banking system) since January 2010 and the rate now stands at 8.5%. By these increases, India has managed to control inflation and the wholesale price index (the Indian benchmark price index) has fallen to 6.6% in January, its lowest level since November 2009. This has obviously come at a cost and GDP growth declined to around 7% in 2011 from 9.6% in 2010. For this reason, Indian policymakers have had no choice but to consider easing monetary policies to prevent a further deterioration in economic growth. At its recent meeting, the RBI cut the cash reserve ratio, although it left the repo rate unchanged.
Economic expansion in India has been slowing since early 2011. We forecast an economic growth around 7% for 2012 for India. Although there are signs of weakness in different sectors of the economy, private consumption is expected to begin to pick up in 2Q12 encouraging more investment and output expansion. The services sector is the main driver of economic growth in India and it is expected to growth by 9% in 2012 down from around 10% in 2010. The constraint to economic expansion is believed to be infrastructure bottlenecks, a shortage of skilled labour and lower productivity in more traditional sectors of the economy.
The rupee is expected to depreciate in the short-term as a widening trade deficit and public sector borrowing requirements put pressure on the currency. However, if economic growth turns out to be higher than expected in 2H12, there is room for a modest appreciation of the rupee considering the lower economic growth of India’s economic partners in the OECD. The current account deficit is forecast to widen in the short term to around 2.8% of GDP in 2012 (EIU, March 2012). It is expected that manufacturing export growth will decline while service sector exports will remain strong, albeit with decreasing growth rates as information technology and business processes continue to attract foreign investments. According to the EIU (March 2012), capital inflows have been financing India’s persistent current account deficit. The deepening sovereign debt crisis in the Euro-zone and low economic growth in the US and other OECD countries pose the risk of downside trend of FDI in India, which could further deteriorate its growth prospects.