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India's GDP seen rising but skepticism remains

An employee serves customers inside a branch of Gramin Bank of Aryavat (GBA), sponsored by Bank of India, in the village of Khurana, Uttar Pradesh, India, on Monday, April 13, 2015.
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An employee serves customers inside a branch of Gramin Bank of Aryavat (GBA), sponsored by Bank of India, in the village of Khurana, Uttar Pradesh, India, on Monday, April 13, 2015.

Growth in Asia's third-largest economy likely picked up pace during the July-September period but don't cheer just yet, economists warn.

India's real gross domestic product (GDP) is expected to expand 7.3 percent on year, up from 7 percent in the April-June quarter, on the back of improved consumption and rising industrial production, according to widespread estimates from private sector economists.

Discretionary consumer spending has been holding up better, reflected by a 9.5 percent annual rise in September car sales, Morgan Stanley pointed out in a Monday report. Meanwhile, positive factory production is another bright spot, with annual industrial output expanding 4.2 percent in July, 6.3 percent in August and 3.6 percent in September.

The upshot is ultimately buoyed growth, but it's still far from full-throttle, said Vishnu Varathan, senior economist at Mizuho Bank.

"Admittedly, with softer inflation boosting consumption, a less dire-than-expected monsoon outcome and nascent industrial uptick, India is still the bright spot in Asia. But growth momentum is not, as yet, on a solid footing."

Experts widely agree that India's biggest problem is a negative output gap, i.e. the difference between actual production and what could be produced under full capacity.

"We believe that the root cause of the challenging macro environment in India over the past few years has been the sharp deterioration in the productivity dynamic. This stemmed from a high fiscal deficit, high rural wage growth, negative real interest rates and slowdown in the government's executive decision-making process," Morgan Stanley said.

The Reserve Bank of India (RBI) has slashed interest rates by a total of 125 basis points throughout the 2015 calendar year, but that's failed to trickle down to Indian companies. Capacity utilization rates, a measurement of factory output, eased to 70 percent this year from over 80 percent in the 2011-2012 fiscal year, suggesting significant slack in the system, according to DBS.

"The stock of stalled projects climbed in the September quarter, while existing capacity is being underutilized. This has, not surprisingly, lowered interest in greenfield investments, with industrial credit loan growth stagnating in single-digits," the bank said in a note over the weekend.

Bank loans given to companies and individuals, known as non-food credit, has averaged 9.5 percent on-year so far this fiscal year, down from 11 percent last year and well below the average of 16 percent in the 2012-2014 fiscal years, DBS said.

The infrastructure and manufacturing sectors make up the bulk of stalled projects and severely hurt balance sheets of both corporate sector and public sector banks, which in turn constrains overall future private investments.

"What's more, the Bihar elections disappointment does not help assuage worries about the Bharatiya Janata Party's (BJP) ability to enact reforms for sufficient investment pick-up," said Mizuho's Varathan.

The BJP lacks majority in the upper house of parliament where it has struggled to push through much-needed reforms. While the government responded to its election defeat in regional polls in the eastern state of Bihar by relaxing foreign investment rules in a slew of sectors, some observers viewed the setback as a symbol of dimming confidence in Modi's pro-business reform agenda.

Moreover, India's consumption outlook is weighed down by a discrepancy between urban and rural areas.

"The continued weakness in external demand and slowdown in rural consumption spending are holding back the pace of recovery," Morgan Stanley (MS) said, citing the impact of weak agricultural growth on rural incomes as a result of tepid rainfalls.

But India's troubles may not last for long, according to the bank, which is forecasting April 2015-March 2016 GDP at 7.5 percent, from 7.3 percent in the previous financial year.

"India is one of the few emerging economies to have completed the painful macro adjustment process—it is now on the path of recovery."