For the year 2011-12, the INDIA LINK model revised its GDP growth forecast downwards from 7.8 per cent to 7.2 per cent, as predicted in April 2011. This expectation of lower growth is due to the prevailing conditions in the domestic and external sectors.

Since our April 2011 forecast, two rounds of interest rate hikes (following rigid inflationary conditions and debt concerns in the EU region) are expected to have a negative impact on growth by holding up investments and suppressing demand conditions. However, the external risks are expected to be much more severe in 2012-13, and may impinge on any recovery in growth. We expect growth to remain at less than eight per cent in 2012-13. These trends clearly indicate that reaching the pre-crisis growth rate may take a much longer time than expected.

The table below provides the key forecasts:

Year	2008-09	2009-10	2010-11	2011-12 (F)	2012-13 (F)
Agriculture	1.6	0.2	5.4	3.7	4.9
Industry#	3.9	9.3	8.2	6.4	8.3
Services	9.8	8.5	9.4	8.3	7.8
Real GDP	6.7	7.4	8.6	7.2	7.4
WPI	8.4	9.9	8.9	7.2	6.7
Exports	3.4	-4.7	20.6	24.1	12.9
Imports	14.4	-8.2	26.6	21.1	11.3
#: Industry includes Manufacturing, Mining & Quarrying, Electricity, Gas & Water Supply *: Forecasts from the quarterly INDIA LINK macroeconometric model

The key assumptions for important exogenous variables for the year 2011-12 are:
- The interest rate hike cycle to peak by the third quarter of 2011-12 and is then expected to move downwards from the second quarter of 2012-13;
- Stability in the MENA region (particularly when Libya restarts its production) to bring down world oil prices to an average USD 100 per barrel;
- Global consumer price inflation and food inflation to decelerate marginally;
- Advanced countries’ output to grow as per OECD projections (which has been revised downwards to 1.6 per cent and 1.5 per cent for 2011 and 2012 respectively);
- A normal monsoon;
- A modest recovery in foreign investment inflows in 2012-13 (especially FII flows that were negative in the recent period)  

This time around, twin deficits are expected to pose substantial downside risks to growth. In the April 2011 forecasts, we assumed that the fiscal deficit would broadly follow the fiscal consolidation road map exogenously. However, the fiscal deficit has now been made endogenous as there are strong reasons to believe that current year’s fiscal deficit would be much higher than budgeted level of 4.6 per cent, particularly after the introduction of the second supplementary demand for grants in the Winter session of Parliament. This is expected to have an adverse impact on private investment demand through a rise in interest rates. Another factor is the worsening of the current account deficit, despite a sharp rise in exports in the first half of 2011-12. In a situation where the external demand outlook is pessimistic until the end of 2012 and there is limited space for Central Bank’s intervention in the foreign exchange market, the depreciation of the rupee and the subsequent rise in import costs could further widen the current account deficit.     
    
On the inflation front, thirteen rounds of interest rate hikes since March 2010 appear to have yielded little result. While it is pertinent to understand the changing nature of monetary transmission and its lags (on containing demand-side pressures), it is also necessary to look at the fiscal policy stance, which was expected to follow a stringent consolidation path. Above all, in our view, the current inflation is largely a combination of ‘postponed’ (or ‘suppressed’) and ‘policy induced’ factors that have resulted in a permanent shift in the trend inflation. With these conditions and with the assumption of a normal monsoon, inflation for the current year end is expected to be at 7.2 per cent and at 6.7 per cent for 2012-13. Depreciation of the rupee/USD exchange rate might pose some further risks through imported inflation.     

In our April 2011 report, we had said that there is a risk of current account deficit in the economy. Since then, the risk perception appears only to have increased. The outflow of FII investments, widening trade deficit and negligible FDI flows are appearing to put pressure on the external account. This is despite a higher interest rate differential, which is a major determinant in favour of the rupee. Higher and unpredictable exports growth, which averaged nearly 50 per cent for the first half of 2011-12, appears to be unsustainable in the rest of the year due to the deterioration in external demand. For the whole year, our model predicts exports growth of 24.1 per cent. Imports, on the other hand, are expected to continue growing at around 20 per cent.    

On the supply side, agriculture output is expected to grow above its trend level, following a normal monsoon. However, it is not clear if there is any supply response due to a sustained spell of higher food prices. On the industrial front, demand conditions (both domestic and external) appear to have started pulling down growth. Greater concern is on the liquidity conditions in the banking sector, which may hamper credit flow to the industrial sector. In addition to this, ambiguity in the mining regulations and an uncertain outlook could result in negative growth in both, the mining and capital goods sectors. The overall industry growth is expected to decline to 6.4 per cent from 8.2 per cent last year. We expect a recovery in 2012-13, as we assume downward movement in the interest rate cycle.

Following the trend in the industrial sector, the services sector’s growth is also expected to decline to 8.3 per cent in 2011-12. Although the first half of 2011-12 has witnessed growth of 8.8 per cent, the deceleration in the construction sector (2.7 per cent in the first half of 2011-12, as compared to 7.2 per cent in the previous year), which is expected to deepen further in the remaining quarters, could pull down the overall services growth. In 2012-13 though, the decline could be larger. Our model predicts a growth of 7.8 per cent, which may be the lowest in a decade.    

Thus, based on the recent developments in the domestic and international markets, GDP growth is expected to see a decline to 7.2 per cent for 2011-12 and 7.4 per cent for 2012-13. As external conditions are not conducive to higher growth, in the medium term there is a need for a shift from an export-led strategy to domestically driven growth, with more reforms to reduce supply bottlenecks.

- Pami Dua, Head, Department of Economics, Delhi School of Economics
(With Inputs from N R Bhanumurthy, Professor, National Institute of Public Finance and Policy)

Disclaimer: Due to the norms of the Ministry of Finance, the figures in this column are as per financial year and not as per calendar year.