Radhika Rao, Executive Director and Senior Economist at DBS Bank believes three themes – boosting cyclical momentum, maintaining the capex drive, and ensuring continuity in governance/reform agenda - will make economic outlook brighter for India.

Maintaining the reform agenda by the government, which is one of the three themes, is crucial for economic growth, she feels. A host of reform building blocks have been undertaken by the government in the past six years – plumbing, lower costs, monetary policy, and addressing legacy baggage.

On the Fed fund rate cut, Radhika Rao said with growth and inflation both running above trend, it would become increasingly hard for the Fed to cut month after month. "Our baseline assumption is for 50 basis point cuts in 2H-2024 by the Fed subject to the evolving economic conditions."

Which are the top three themes on your radar that will make India's economic outlook brighter?

We would classify these themes into 3 Cs – boosting cyclical momentum, maintaining the capex drive, and ensuring continuity in the governance/reform agenda. Boosting cyclical momentum will require authorities to support the manufacturing push, generating sufficient employment to absorb the economy’s demographic dividend. Additionally, stronger revenue generation can be geared towards continuing to improve the quality of expenditure, which will carry tangible benefits for the economy.

The ongoing capex boost is being led by the government as well as households, with the latter increasing investments into real estate, reflected in higher housing sales and credit growth. The private sector has also invested albeit selectively, particularly in sectors with backward linkages to the government’s infrastructure push, with a larger pickup in machinery & equipment still to show its hand.

On the third, maintaining the reform agenda is crucial. A host of reform building blocks have been undertaken in the past six years – plumbing (streamlining the application process, the introduction of the bankruptcy law, unified GST, digital initiatives including subsidy payments), lower costs (corporate tax cut, fiscal support like the Production Linked Incentive, sector-specific programs, interest subvention, etc.), monetary policy (inflation focused), and addressing legacy baggage (cleaner books of key economic agents (corporates, banks, etc.).

The cumulative impact of these reforms is likely to reflect in the improving total factor productivity trends (residual after capital and labour contributions have been accounted for). Political developments will be front and centre of the discourse in the near term.

In our pre-election study, on average, growth slows a quarter before the elections, but rises three quarters after, by an average of ~60-100bps. As election-related uncertainty eases, private sector investments return, and the government resumes capex spending plans. Lagged impact of any consumption-boosting measures also boosts spending.

Do you expect the foreign fund inflows to significantly increase exposure to INR sovereign bonds given the Indian bonds inclusion in global indices by JP Morgan and Bloomberg?

These inclusions stand to improve the demand-supply dynamics for sovereign bonds by tapping a significant under-realised investor group. In the decade up to FY23, net borrowing has financed an average of ~70 percent of the central government’s fiscal deficit, the majority of which is held by domestic commercial banks, followed by real money investors like insurance companies.

Overall foreign portfolio investors’ (FPI) ownership of total outstanding bonds has been less than 2 percent in the last two years. Under the Fully Accessible Route (FAR) securities, Indian Government Bonds are currently under-owned, with FPIs holdings at less than 5 percent. A pick-up here would act as an additional source of financing for the INR government bonds, helping with the supply-demand dynamics. Higher participation by ‘stickier’ passive investors will also help the overall balance of payments position, as foreigners remained net sellers on the portfolio front (equity and debt) in the last two years.

Post this inclusion, passive flows of $20-35 billion are expected to be drawn in as the weightage increases, besides incremental flows from actively managed funds in the run-up. Subsequent second-order benefits are also notable. Corporates are expected to benefit as the yield curve could shift lower, reducing the cost of financing. Non-bank financial firms particularly have been active in the domestic corporate bond markets.

At the same time, the pressure on the commercial banks to absorb most of the government’s borrowings will also be lower, especially as the investments under the statutory window are higher than required at this juncture. Anticipation of further portfolio flows is likely to convince the authorities to continue absorbing flows passively to bolster defences and keep the rupee on a predictable as well as stable path.

Do you think the Federal Reserve will go for one interest rate cut in the current year instead of three earlier, considering the current economic data?

Given upside surprises to US core CPI and PCE inflation since the March FOMC, the Fed will have to acknowledge slower progress in returning inflation back to the 2 percent target. According to our US Economist, the markets, belatedly but rightly, have realised that short of a major negative shock, it will be hard for Fed to justify substantial rate cuts in this cycle. The clamour for rate cuts stems from notions of fiscal and financial dominance.

There is this implicit view that given the large deficit-debt dynamic at the public sector level, and likely balance sheet risk of the financial sector from a prolonged period of relatively high nominal and real interest rates, there is only so long before something destabilising happens. This notion has proven to be incorrect so far.

US households and corporations have come across with modest duration risks, having locked into the historically low rates on their debt during the pandemic years. Rising yields have not caused bond market volatility to go up, with substantial private sector demand for US treasuries. Other than a few regional banks, the financial sector has also displayed considerable capacity to absorb the high rates, commercial real estate market stress notwithstanding.

With growth and inflation both running above trend, it will become increasingly hard for the Fed to cut month after month. Our baseline assumption is for 50 basis point cuts in 2H-2024 by the Fed subject to the evolving economic conditions.

What will be the major risk factors for global central banks?

A slower pace of disinflation, rebound in commodity prices, the geopolitical situation, and credit accidents are potential risks. The impact of these factors will vary, from stoking inflation higher at a time when growth is moderating, to adverse spillover effects on emerging markets from unexpected credit events.

Do you see India growing more than 7 percent (forecast set by RBI) for FY25?

Two-way developments increase the probability that this year’s growth will be in the vicinity of the RBI’s target and our revised growth forecast of 7 percent. High frequency indicators suggest Q4FY24 GDP growth is likely to be above 6.8 percent year-on-year, implying an upward revision to our FY24 real GDP growth forecast. Cyclical and structural factors have turned conducive for the trajectory, helped by early signs of an improvement in rural demand, and a recovery in household-led capex, which is moving in sync with the government’s higher allocations towards infrastructure.

We recently revised up our FY25 growth to 7 percent from 6.5 percent earlier, assuming better rural demand benefits from a normal monsoon, wealth effects from buoyant capital markets, post-election pick-up in corporate capex, manufacturing lift and improving composition of the trade sector. An improvement in external balances, including the current account and gross external financial ratio, point to stronger defences in the face of global volatility.

The upcoming index inclusion augurs well for portfolio inflows, with higher reserves helping to limit large swings in the currency. Potential impact on farm output from a heatwave, which coincides with reservoir levels at multi-year lows, is a key risk to monitor. Rate cuts stand to be delayed considering firmer growth momentum, above-target inflation and US rates that expected to stay higher for longer. Geopolitical tensions and their potential impact on oil/commodity prices will be under watch.

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