Long-term structural strengths and resilience of the Indian economy to continue despite cyclical challenges

After being one of the best-performing emerging markets in 2021, India equities have experienced increased selling and net foreign capital outflows in the first quarter of 2022. While there are numerous reasons for the marked change in sentiment, the recent sharp rally in crude oil prices has served as a key factor.

The recent significant change in the global macro backdrop may raise questions among investors, particularly concerning the sustainability of India’s post-COVID-19 economic recovery in the new environment. Given the current geopolitical uncertainty and the subsequent effect on oil prices, we’ll focus on key areas of importance for India and how these developments have affected our views. 

1 The long-term structural growth story that we previously laid out—formalization, digitization, and manufacturing revival, all of which are supported by government policy—remains intact despite short-term pressures. 

2 In the current cycle, we think the Indian economy is more resilient to oil price shocks than in the past. This strength is underpinned by the reform-led structural changes of the past eight years.

3 Finally, we discuss calibrating our sectoral views based on the current situation.

India’s structural investment story remains intact

Despite recent cyclical challenges, India remains a local and bottom-up investment story with a stable regulatory environment. As we highlighted previously, this is due to two consecutive series of government reforms that jump-started the country’s structural and transformative journey in 2014: 

1 Formalization reforms,¹ which we described as the 4Fs (formalization, fiscal stability, financialization, and reforms), created a more formal economy that improved India’s potential growth prospects. These important reforms laid the foundation for India’s growth agenda.

2 The economy also benefited from the government’s recycle, rebuild, reinvest (3Rs) framework, which aims to increase India’s manufacturing share of GDP through a comprehensive policy push.²

We previously explained that the fusion of these structural changes has created two powerful themes that should serve as the primary drivers of India’s medium-term growth trajectory: the formalization of the economy leading to an expansion of the digital economy and reinvestment driving manufacturing growth.

The oil price shock may hasten India’s economic transformation

External macro shocks have already played a key role in hastening India’s economic transformation. The COVID-19 pandemic accelerated economic reform as the government pushed through long-term policy changes under the formalization and 3Rs framework.

We believe the potential pressure that higher oil prices exert on the country’s external accounts this year may catalyze a similar outcome and accelerate policy efforts to realize India’s potential of increasing manufacturing reinvestment through the government’s Production-Linked Incentive (PLI) schemes. Indeed, at the core of the reinvestment policy is the government’s aim to reduce India’s dependence on imports and promote greater onshore manufacturing. 

We estimate that oil imports will represent around 26% of India’s total import bill in financial year (FY) 2022.³ While India will need to import crude oil for the foreseeable future, the government is encouraging domestic investment for other significant noncommodity items under the PLI schemes through:

• Import substitution (e.g., mobile phones, telecom equipment, air conditioners)
• Export growth in industries with strong domestic manufacturing capability (e.g., automobiles, pharmaceuticals, textiles, chemicals)
• Promote new growth areas to increase future self-sufficiency (e.g., photovoltaic cells, advanced chemistry for batteries)

Indeed, this dynamic is already playing out as India achieved solid growth in domestic electronic manufacturing that should lead to high export growth of around 33% in FY22.³ We believe the PLI schemes will attract significant investment and incremental added value of ₹30 trillion to ₹35 trillion (US$400 billion–US$466 billion) over the next five to seven years, thereby improving manufacturing’s share of GDP.³

As this happens, it should create another virtuous cycle as more added value in manufacturing will increase net exports, thereby raising domestic savings. This, in turn, will improve government finances and ultimately reduce the cost of capital, affording the government fiscal room to support the country’s manufacturing sector with better infrastructure and incentives.

Policy consistency can be seen in February’s Union Budget, which focused on capex growth and cuts in fiscal subsidies. It also increased the directed benefits for domestic manufacturing, strengthening supply-side reforms that raised the economy's long-term growth potential.

India’s increased resilience to higher oil prices

India is the world’s second-largest net importer of oil. If oil prices are sustained beyond US$100 per barrel for an extended period, it could potentially create negative cyclical pressures on the country’s economy.

According to our estimates, which assume that higher average oil prices are sustained for a one-year period, every US$10/barrel increase in the oil price could widen India’s current account deficit by roughly US$15 billion. We think that India’s overall balance of payments could swing from a surplus to a deficit if crude moves beyond US$90/barrel. The cyclical pressure brought about by higher oil prices should transmit through the domestic economy through four channels: 

1 A larger oil import bill will reduce national savings and widen the country’s current account deficit

2 Increased domestic inflation and reduced policy room for the Reserve Bank of India to maintain an accommodative policy stance

3 Lower real GDP growth in the short term as domestic consumption and capex adjust to lower savings and/or increased cost of capital

4 Higher raw material costs and lower volume growth for corporates; current earnings estimates will need to be adjusted lower  

How oil price changes can affect growth in India

Source: Ministry of Finance, the Reserve Bank of India, Kotak Institutional Equities, Manulife Investment Management, as of March 1, 2022. The base-case scenario is analyzed before the recent oil rally. Inflation and fiscal deficit projections assume a 25% and 50% absorption by the government with Brent crude prices at US$100/barrel and US$120/(sustained over a one-year period from April 2022–March 2023), respectively, by cutting retail fuel taxes. 

While these cyclical challenges are significant, we should also understand why the Indian economy is now more resilient to oil price shocks relative to the past. The increased resilience will ensure that the cyclical problems won’t damage the economy’s long-term potential and maintain overall macro stability. In our view, there are three factors underpinning this important change. 

1 Stable current account deficit and growing export-to-GDP ratio—Thanks to a comprehensive policy agenda to improve domestic manufacturing, India has boosted its global products market share (particularly in electronics and chemicals) and enhanced the resilience of its current account over the last four years through growing the share of its exports as a percentage of GDP. 

2 Manageable fiscal deficit—We expect the government to cut the excise duty on fuel to soften the blow to consumers and contain the impact on real GDP growth. Even after absorbing 50% of the impact, we believe the overall deficit should align with the government’s medium-term fiscal goals. While this may widen the fiscal deficit, it should still be within tolerable limits.

In our view, the recent budget’s tax estimates were quite conservative. We expect the actual fiscal deficit to be 50 basis points lower than budget estimates, primarily driven by better-than-budgeted Goods and Services Tax collection levels.

3 Robust foreign exchange reserves and import cover—India’s foreign exchange reserves are at a near all-time high, driven by structural improvements in the country's  current account and strong foreign portfolio and direct investment flows. India’s current foreign exchange reserves’ import cover is much higher than between FY12 and FY14, when the price of crude oil stayed consistently above US$100/barrel. This should lend added stability to the rupee and potentially mute amplification of imported inflation.

Impact on industry views amid heightened geopolitical risks

Should current geopolitical tensions and energy market imbalances continue for an extended period, we expect to see cyclical pressure on India’s growth outlook in calendar year 2022, given elevated energy prices and a higher external account.

However, this doesn’t detract from the country’s reform-driven longer-term growth story. If anything, this is likely to strengthen the government’s reinvestment-led reform agenda that’s designed to reduce net imports. As mentioned, even if the average crude oil price reaches US$120/barrel, the effect on real GDP growth and inflation can be partly mitigated by the available fiscal buffer. Of course, if oil prices were to rally and move beyond the levels we envisaged in our assumptions, it would add further pressure to macro stability and growth estimates. Ultimately, this remains a critical risk to our outlook.

Despite near-term cyclical pressure, India is likely to remain one of the fastest-growing large economies in FY22 and FY23, as the country’s service sector revives as its adult population becomes fully vaccinated. We also note that while real GDP growth wi