Ongoing recovery 

The Indian economy is set to expand further in 2022, building on its 2021 gradual recovery. Private consumption (59% of GDP) rose by 9.3% in January- September 2021 and nearly returned to 2019 levels as the labor market improved. The unemployment rate fell from 11.9% in May 2021 at the peak of the Delta wave to around 7% in November 2021. Mobility at recreation, retail, and transit stations broadly normalized to pre-pandemic levels. However, intense inflation pressures could weigh on consumption, and households could increase their precautionary savings due to more significant inflation uncertainty. As reflected by gross fixed investment levels (29% of GDP), business confidence also improved, restoring to just shy of the 2019 level in the first three quarters of 2021. Public investment (6.9% of GDP) should also be boosted by higher budget allocation (34.5% more in FY21-22 than FY20-21) amid the push to develop much-needed infrastructure under the National Infrastructure Pipeline (NIP) plan to be executed over five years (FY2019-25).

Before the pandemic, India’s private domestic demand had waned due to policy reforms, including the banknote de-monetization in 2016 and the goods and services tax (GST)’s implementation in 2017, leading GDP growth to slow since FY2017 and reached 4% in FY2019. We see the gradual recovery in consumption and investment amid persistent downside risks, especially potential virus resurgences. While the share of the population fully vaccinated (at 40% in mid-December 2021) continues to lag most of its regional peers, a higher seroprevalence rate could mitigate risks from future waves. On the supply side, manufacturing (16% of GDP) has rebounded solidly, with output already back to the pre-pandemic level. In comparison, services (50% of GDP) were resilient, led by software services (5% of GDP). Coal shortages have seen India increase production to feed its power plants.

The central bank’s stress tests results in July 2021 and the lifting of a temporary measure to suspend recognition of pandemic-affected loans as nonperforming suggest that nonperforming assets (NPAs) of banks and non-banks may rise, despite extensions to the credit guarantee scheme (till 31 March 2022) for MSMEs and loan restructuring scheme. Despite policy support, bank credit growth has remained subdued. Anticipating a possible surge in NPLs, banks have increased provisioning and raised capital. The government also announced in September 2021 the establishment of a distressed debt bank (National Asset Reconstruction Company Ltd) to acquire up to INR 2 trillion of bad loans. In October 2021, the minimum capital buffer was raised to 2.5%, thereby increasing the minimum CET1 capital ratio to 8%.

Weak public finances 

The pandemic has further weakened the fiscal position, with the general government fiscal deficit ballooning to a record 12.8% of GDP in FY20-21 due to economic contraction, lower revenue, and support measures. However, the fiscal deficit is expected to narrow as some efforts are scaled back amid the recovery. The FY21-22 budget focuses on health-related and infrastructure expenditures, and the FY22-23 budget should maintain a mildly expansionary fiscal stance to support the recovery and improve the infrastructure. Therefore, public debt should remain high relative to the pre-pandemic period but overwhelmingly domestic. Over the medium term, the government is committed to fiscal consolidation, helped by improvements in GST and income tax buoyancy.

The current account balance is expected to have returned to its usual deficit in 2021, with this shortfall widening in 2022 due to a gradual recovery in domestic demand and higher oil prices. The drought in the net goods balance for the first half of 2021 was nearly half the pre-pandemic level. Meanwhile, Indian I.T. services remain in solid demand, helping to keep the services trade balance in a healthy surplus (3% of GDP). Moreover, India has the largest diaspora population in the world, whose remittances have contributed to a resilient rest in the secondary income account.

Increasing political pressure

A weakening economic trend in recent years, rising fuel prices, and growing dissatisfaction over the government’s pandemic response pose a political challenge to the administration. In a sign of increasing political pressure, Modi announced on 19 November 2021 that he would repeal the controversial agricultural reform laws after the year-long farmers’ demonstrations, followed by a parliamentary vote to scrap the three farm laws aimed at liberalizing agricultural markets. Nevertheless, fragmented opposition and limited national appeal for most opposition parties (including the main one, the Congress party) means that the BJP is unlikely to see a serious challenge. Meanwhile, the India-China relationship remains strained amid border issues and India’s renewed commitment to the Quadrilateral Security Dialogue that includes the U.S. and its bolstered defense ties with Australia and Japan. On the trade front, India is unlikely to join the RCEP due to concerns about a considerable inflow of imports from more competitive regional peers. Instead, India seeks to revive trade talks with the E.U. and a potential free trade agreement with the U.S.