India's Double Whammy: Slower Growth, Higher Inflation

There are dark clouds on the horizon for India's economy, say analysts who forecast  growth in gross domestic product (GDP) to fall below 8 percent thanks to high inflation, which has prompted the Reserve Bank of India to raise interest rates by over 200 basis points over the past one year.

Indranil Mukherjee | AFP | Getty Images An Indian stock broker watches his computer screen at brokerage company at the Mumbai Stock Exchange.

On Tuesday the central bank raised interest rates by 50 basis points, which was higher than market expectations.

Says Robert Prior-Wandesforde, Director of non-Japan Asia Economics at Credit Suisse,  “It’s just an awful macro combination for India right now.”

Credit Suisse expects Indian economic growth to slow to 7.5 percent this year from 8.6 percent last year. That is lower than RBI’s forecast of 8 percent and the government’s projection of 9 percent.

High Inflation, slowing capex investment and rising interest rates are eating in to India’s growth story.

Industrial output growth slowed to 3.6 percent in February from 3.9 percent in January.  Inflation accelerated to 9 percent in March from 8.3 percent in February and the RBI said Tuesday that corporations are concerned about sluggish demand ahead.

“There are definitely challenges to continue the growth of the economy in the current year,” says Jigar Shah, Senior Vice President and Head of Research at Kim Eng India, a Mumbai-based brokerage.

War on Inflation

While the RBI has been raising rates regularly to deal with inflation, the battle is far from won. According to Prior-Wandesforde, it takes about 12 to 18 months for the rate hikes to take effect. Therefore this year will see the cooling effect from the buildup of previous tightening measures.

According to Vishnu Varathan, Asia Economist from Capital Economics, the RBI is expected to raise interest rates at least one more time before the end of the year - even though it said Tuesday after its policy meeting that it was seeing a deterioration in the availability of finance and working capital requirements and the cost of external finance was rising.

“The real cause of concern is that underlying inflation is also rising,” says Varathan.  India’s March core inflation rose 7.1 percent versus 6 percent in February.

“The main worry, especially from a policy standpoint, is that inflation is not purely a supply side phenomenon. Along with rising core inflation, non-food manufacturing inflation has also picked up significantly,” says Varathan.

Worsening Investor Sentiment

Falling investor confidence is also reflected in the Indian equity market, which has been the worst performer in Asia this year. The benchmark Bombay Sensex has lost about one tenth of its value since the beginning of this year, worse than the Japan market, which suffered from a major earthquake in March.

“I can’t argue against the fact that sentiment towards Indian equities is poor,” says Sarah Lien, Senior Research Analyst from Russell Investments. The company surveys investor sentiment by interviewing money managers.

However, Lien noticed some improvement in the sentiment. “Many money managers that we speak to are warming up to this market again on the belief that bad news and bad sentiment have been factored into stock prices. They are using this as an entry point to invest back in India, but selectively.” Lien says.

The Indian equity market saw a net inflow of $1.5 billion from financial institutional investors in March, after negative FII flows in January and February.

Yet many still believe the market will need to consolidate before bouncing back again. “[Tuesday’s] rate hike means the worst is not over yet,” says Credit Suisse’s Prior-Wandesforde.