Analysis: Struggling Indian economy hardens case to end policy

By Tony Munroe

MUMBAI (Reuters) - India is nearing the end of its credit tightening cycle, as 10 interest rate increases since March 2010 exact a toll on growth in a once-roaring economy, making Tuesday's expected rate rise potentially the last for the near future.

However, recent industrial output and manufacturing data was the worst in nine months, car sales are skidding and loan demand is slowing, even as the central bank readies yet another increase in interest rates.

India's dream of annual growth of 10 percent appears increasingly distant.

The rate increases have been needed to fight persistent inflation, which is running about 9 percent and some economists predict a return to double-digits.

"We haven't seen, or are at the very early stage of seeing the lagged effects of all the interest rate hikes," said Credit Suisse economist Robert Prior-Wandesforde in Singapore.

"That's only just started, and I think that's going to deal a much heavier blow to growth as we go forward," said Prior-Wandesforde, whose forecasts for Indian growth of 7.5 percent this fiscal year and next are among the lowest.


A Reuters poll of more than 20 economists forecast growth in the fiscal year that ends in March 2012 will be 7.9 percent, quite a drop from last year's 8.5 percent. But the crowd is sanguine about prospects for the year that ends in March 2013, forecasting a growth rate of 8.4 percent.

This year, sluggish investment due to rising rates and government paralysis in the wake of corruption scandals has slowed the building of additional capacity, which in turn has added to inflationary pressures on the supply side of the manufacturing sector.

All in all, the onus of arresting double-digit price rises has been left entirely to the Reserve Bank of India, which has managed to rein in credit growth and the stock of cash in the banking system but with unintended consequences.

Car sales in India, which jumped 30 percent in the year through March, grew by just 1.6 percent in June, their slowest in two years, as higher interest rates and more expensive diesel and petrol deterred buyers.

Loan growth has cooled to below 21 percent on an annual basis after reaching 25 percent at the end of 2010, with further slowdown expected as credit becomes more costly. Manufacturing surveys indicate further slackening in demand and therefore production.

Even at an 8 percent pace, India will be the second fastest economy in Asia, but it needs to grow quickly in order to raise living standards and create jobs for a surging working age population.

There is no sign at all of a possible plunge in growth to a "hard landing," which is technically difficult to define but conceptually would mean India couldn't generate the number of new jobs needed for its young population or the revenue gains the government requires to contain its fiscal deficit.


That would spawn a vicious cycle of more government borrowing and higher yields, possibly monetary easing and therefore inflation.

India is cushioned from a precipitous fall in growth by an absence of major asset bubbles. Mumbai stocks are among the world's worst performers in 2011, down about 10 percent this year, and property prices have been sluggish for months.

Also, demand is expected to remain robust, thanks to rising rural incomes that are less sensitive to interest rates.

Some analysts have worried China could have a hard landing. But its data showing annual growth of 9.5 percent in the second quarter, compared to 9.7 percent the previous quarter, have doused fears.

For India, there are different views about what would constitute a hard landing.

At the upper end, HDFC Bank Chief Economist Abheek Barua characterizes it as growth below 7.5 percent for a fiscal year. Other economists see hard landing as growth below 7 percent or around 6 percent.

For Credit Suisse, it would mean consecutive quarters of growth of 5 percent or below, an outcome that would be disastrous for the government.

With New Delhi only recently showing fiscal discipline with last month's long-delayed 9 percent increase in diesel prices, and capacity bottlenecks slow to clear as big projects and reforms stall, fighting inflation has been left to the central bank.

"Unfortunately what has happened in India is that fiscal policy is almost oblivious to inflation," said Samiran Chakraborty, chief economist at Standard Chartered in Mumbai.

"All the burden has come to rest on interest rate policy, which is a pretty blunt instrument," he said.

The wholesale price index (WPI) rose 9.44 percent in June after the diesel increase began to take effect.

Amid expectations that inflation will stay high the rest of 2011, the central bank has little choice but to raise rates again at its July 26 review.

All 23 analysts polled by Reuters expect the key policy rate to be raised 25 basis points that day to 7.75 percent. Eleven expect that following Tuesday's meeting, there will be one more 25 basis point rise in 2011, but nine see the Reserve Bank of India keeping rates unchanged after July 26.


Despite the series of policy rate increases, real interest rates in India are near zero, with the one-year deposit rate at around 9 percent -- roughly in line with inflation -- compared with the central bank's benchmark repo rate of 7.5 percent, a level economists expect to top out at 8 percent.

There is a prospect that a government on the back foot over its handling of corruption, inflation, and now security after the July 13 bomb attacks in Mumbai, may push through measures to stimulate investment that would drive growth and address supply shortages.

In this optimistic view, Indian growth is bottoming, and long-delayed projects such as POSCO's $12 billion steel plant are poised to move forward, providing a shot of investment-driven stimulus.

New Delhi is also believed to be moving closer to enabling foreign direct investment in multi-brand retail, a politically difficult step aimed at improving supply chains and curbing inflation in a country where 30 percent of produce rots before it gets to market.

"I think the government has finally woken up to the fact that things are looking fairly difficult, at least on the industrial economic front," said HDFC Bank's Barua.

(Editing by Richard Borsuk)