The Indian economy witnessed a record GDP contraction of -23.9% y/y in 2Q (1QFY21), starkest decline in the region (and major economies), owing to one of the most stringent lockdowns imposed to halt the pandemic spread. The supply-side measure, gross value added (GVA) contracted 22.8% y/y vs 3% in 1Q. This is seen as the economy’s weakest performance since the quarterly GDP is being released since 1996.
Declines in sub-sectors were broad-based–
– Aggregate demand conditions were downcast, with private consumption (-26.7% y/y) and fixed capital formation (-47%) due to large scale shutdown and movement restrictions. The net demand shock was partly offset by better faring government and net exports (due to weaker imports).
– Of concern was also the tumble in fixed capital formation to 19.5% of GDP in 2Q20 vs 26% in the quarter prior, hastening the downtrend which has been in place for the last two years.
– Under sectors, agriculture (and allied) benefited by minimal restrictions from the virus, and higher production, rising 3.4% y/y. Due to the sudden stop in economic activity elsewhere, sharp declines were recorded in employment intensive sectors of construction (-50% y/y), manufacturing (-39%) and trade, hotels, transport etc. (-47%). Utilities were largely open during the lockdown and contracted by a smaller measure.
– The mismatch between the 16% y/y increase in government consumption (demand-side) but a contraction in public administration, defence and other services (on the supply side) can be put to weakness in ‘other services’ part of the basket, which includes education (tuition/coaching classes), health, personal services etc. which were on a complete lockdown during this period
– Core GVA, which captures private sector activity (excludes agricultural and public administration) fell 29.6%.
-Nominal GDP was also weak, contracting 22.6% y/y, setting the stage for a full-year decline. This will not only hurt corporate profitability but also bodes poorly for credit growth and adding to the deterioration in the deficit/ debt ratios. GDP deflators eased in the quarter and are likely to stay weak as pricing power remains sub-par. Supply-side disruptions have, by contrast, driven the CPI inflation higher in recent months.
This GDP release remains subject to downward revisions given paucity of data during the lockdown. The statistics agency highlighted that “Though restrictions have been gradually lifted, there has been an impact on the economic activities as well as on the data collection mechanisms. Timelines for filing statutory returns were also extended by most regulatory bodies. In these circumstances, the usual data sources were substituted by alternatives like GST, interactions with professional bodies etc. and which were clearly limited.” Proxies were likely used for inflation/ deflators, informal sector data, industrial production, etc., which suggests downside bias to revisions down the quarters, particularly about formal vs informal sector performance. Cost cuts/savings provided a hand to profitability (even as sales underperformed) for the bigger companies, but the limited liquidity headroom for the smaller firms makes it a challenge to maintain margins under challenging conditions.
2Q (1QFY21) degrowth was likely the nadir of the cycle, but a sharper rebound is hamstrung by varying extent of easing in restrictions across districts as the pandemic evolves and broadens its reach. Add to this, ~80% of the total confirmed cases has built up since end-June, pointing to the need to gain an upper hand on the infection curve as a precursor to making recovery sustainable.
Climb out of the trough is likely to be uneven and slow-paced, between supply and demand, industry and services sector performance. Supply is expected to adjust partially ahead of a revival in demand. Consumption weakness in the current cycle stems from weaker disposable incomes and uncertainty over employment prospects, rather than changes in the rate cycle. This requires a larger fiscal push, which carries a larger multiplier than purely easier financial conditions. Stimulus measures from the fiscal route might be in the shape of boost to purchasing power through cash support, reduction in direct/ indirect tax rates, higher infrastructure spending indirectly lifting demand, alongside direct aid to most affected sectors, including discretionary services.
Fiscal headroom is, however, limited. Latest data showed that the cumulative fiscal deficit for the first four months of FY21 (April-July) has already exceeded the INR7.96trn projection for the year, rising to 103% of the budgeted target. This compares to <80% in the comparable period last year. Full year central and state government deficit is expected to exceed 12% of GDP. We still see room for another a more targeted fiscal boost in 2HFY21, but limited bullets suggest the support package is unlikely to effectively boost near-term demand.
Lowering GDP forecasts
Our in-house GDP Nowcasting model points to a smaller, yet double-digit contraction in 3Q (2QFY21). Factoring in a sharper contraction in 1QFY21, delayed flattening in the infection curve, and restrained fiscal space, we now expect GDP to continue to contract in rest of the three quarters of FY21. This also implies a downward revision in our FY21 GDP forecast to -10.5% y/y vs -6.0% previously, assuming the infection curve begins to taper into 4Q20-1Q21, farm output adds to growth and a measured fiscal boost is in store in 2H. A vaccine find or efficient control on the pandemic curve will lend upside bias to our estimate.
Daily pandemic count stays high, Unlock 4.0 gets underway
India’s daily count of COVID-19 cases has jumped in recent days, taking the total number of cases past 3.6million. The country has the third highest number of cases in the world and is closing in on Russia’s count. Silver linings are the improving recovery rate – from sub-60% in June to over 76% in August, as well as a pick-up in testing numbers
Even as the case count continues to rise, the fourth stage of the phased reopen is underway, as focus shifts to protecting livelihoods. Unlock 4.0 will be rolled out this month, with states no longer permitted to impose lockdowns outside containment zones without the central government’s permission. Important changes will include a) resumption of metro services from Sep 7; b) return of up to 50% of teaching and non-teaching staff to schools outside containment zones from Sep 21; c) schools/ colleges will stay closed till end-Sep; d) Maximum of 100 people will be allowed to attend social, cultural, political and religious functions.; e) theatres, pools, entertainment parks, and other entertainment parks will remain closed; f) international air travel stays suspended. States have also announced relaxation in few local rules, e.g. Tamil Nadu, Maharashtra etc.
RBI shows its hand in the debt markets
With growth on the slide and rising concerns over inflation as well as fiscal outlook, Indian 10Y bond yield had hardened in recent sessions, widening the duration premium. To address concerns over premature tightening in financial conditions and prevent a reversal in hard-fought transmission, the central bank showed its hand by a combination of measures on Monday.
Key changes included:
–Special open market operations/ Operation Twist (OT): In addition to INR200bn worth OT announced last week, the RBI announced two more tranches of INR100bn each in September
–Term repo support: An additional term repo operation worth INR1trn will be conducted at a floating rate (repo rate) in mid-Sep. Banks who had borrowed at prior repo operations at higher costs will be given the option to switch to lower current repo rate at 4%
–Hike in the Held to Maturity (HTM): This is seen as the most significant move in improving demand-supply dynamics in the bond markets. Banks will be allowed to hold up to 22% of the net demand and term liabilities (NDTL) in Statutory Liquidity Ratio (SLR) up from 19.5% presently. This will apply to fresh purchases of SLR securities between Sep 1 and Mar 31, 2021. This is expected to add ~INR3trn accrued demand for domestic bonds.
–Strong guidance: Besides undertaking these steps, the central bank also assured that additional borrowings of central and state governments will be conducted in “a non-disruptive manner”.
These measures are likely to provide short-term fillip to domestic bonds helping to calm rising yields as well as flatten the curve a notch to keep borrowing costs in check. With more than half of this year’s bond supply still ahead of us, markets will continue to count on more such supportive guidance and regular open market operations, to help absorb the incremental supply. We retain our expectations for 10Y yields to ease below 6% in 3Q and stabilise in 4Q.
With focus on bonds, RBI’s FX intervention strategy has changed
Recent gains in the Indian rupee vs USD – rupee has appreciated 1.7% month-to-date (August) – have rekindled speculation on whether there has been a shift in the central bank’s intervention strategy, away from the currency and on to the bond markets.
This is borne by slower dollar buying activity in recent sessions, which has in the past kept the INR on a modest weakening bias and aided in accruing foreign reserves by mopping up flows.
A shift was likely driven by –
a) allow FX to catch-up with the regional peers, also supported by foreign equity inflows alongside broad dollar weakness as well as an anticipated balance of payments surplus;
b) recent dollar flows are also related to fund-raising activity by domestic institutions, particularly private sector banks via the qualified institutional placements (QIP) route and FDI inflows;
c) contain inflationary impulses through the imported channel;
d) persistent intervention (via dollar buying) on the FX front had added to local liquidity surfeit. Intervention had been unsterilized, given the need to give bond markets a hand through open market operations. Speculation has, thereby, been that part of the sterilisation was being conducted in forwards instead of the spot.
Persistent foreign reserves accumulation has led India’s stock to witness the highest accretion amongst AXJ in the past 5 years. More recently, this has accelerated – reserves are up ~USD80bn since December 2019, to near record high. India’s stock also fares well on adequacy ratios, providing a cushion in the current challenging economic backdrop (India: Improved external balance a silver lining). We expect reserve accumulation to be a priority for the policymakers, especially if strong flows destabilise FX markets, when inflationary pressures subside.