However, weak performance in the agriculture sector could erode some of these gains. India recently faced one of the worst droughts in 40 years, and an adverse effect on the agricultural sector is inevitable. Should agriculture contract by 5-8%, our 6.4% GDP forecast for FY10 could be at risk by 60-100bps. Though we see downside risks, the lack of clarity on winter crops – dependent on late rainfall – prevents us from making any revisions at this stage. The latest data suggests better rainfall for most of the country and is a positive indicator for winter crops. However, on the flipside, flooding in some states could have affected standing crops. Also, the pace of recovery in the industrial sector could bring a positive surprise on the back of favourable base effects in H2-FY10.

Headline Q1-FY10 GDP growth was in line with market expectations, but the breakdown gives us cause for concern.Domestic demand has always been a primary driver of growth in India. Almost 97% of overall GDP in general is contributed by different components of domestic demand – private final consumption expenditure (55-59%), gross fixed capital formation (32-33%), and government consumption expenditure (9-10%). During the current slowdown, the onus for maintaining domestic demand has fallen on the fiscal authorities. Government consumption contributed one-third of GDP growth in FY09.

Net exports usually trim some growth from the headline GDP number, as India is a net importer. This quarter has been an exception as net exports surprised by contributing 50% of overall GDP growth. However, rather than indicating a pickup in external demand, the higher net exports figure was primarily driven by a much more drastic fall in imports relative to exports, as domestic investment demand was weak. In our view, this is unlikely to be the case in coming quarters, even if export growth numbers turn out to be positive because of last year’s low base.

Growth in domestic demand (the aggregate of household expenditure, government expenditure, and private investment) slowed significantly to 3.2% y/y in Q1-FY10, from 6.2% in Q4-FY09 and 5.51% in Q1-FY09. This is a concern, as it does not tally with our anecdotal evidence. Specifically, private consumption growth of 1.6% represents a steep drop from its peak of about 10% (Q1-FY06). Lower interest rates, a positive wealth effect from booming asset markets, increased certainty in the job market, and an overall improvement in consumer sentiment should all help to drive up urban consumption growth from these abysmally low levels. However, there are risks that rural consumption expenditure (which contributes more than half of private consumption) may not be able to sustain the stellar performance seen in FY09 due
to the poor monsoon. The key challenge for the fiscal authorities will be to halt such a decline through policies designed to sustain rural incomes.

During the boom years, the contribution of investment to GDP growth was almost equal to the contribution of consumption. Investment growth has faced cyclical headwinds since mid-FY08. The situation deteriorated in H2-FY09, when financing constraints (both domestic and external) exacerbated the cyclical pressures. In Q1-FY10, investment growth of 4.2% was paltry versus its cyclical high of around 20% (Q3-FY05). The good news is that capacity utilisation declined only marginally in FY09 – from 83.9% to 81.3% for 296 industries combined. Even the RBI’s Industrial Outlook survey projects a rise in capacity utilisation levels in Q2-FY10, following three quarters of decline. The bad news is that Industrial Entrepreneurs Memoranda (IEM) submitted to government (the first step towards any proposed investment)have not been converted into actual letters of intent (LOI). While IEM rose by 84% in 2008, as of May 2009, the government had not received a single LOI. Anecdotal evidence also suggests that most of the capex in the last fewquarters has been on completing existing projects rather than starting new ones.

Standard Chartered Bank believes that capacity constraints, the improved outlook for external demand, a revival in demand from the private sector, and a relative easing of financing constraints should see capex rise in the next few quarters. A gradual buildup of inventory is already reflected in the Q1-FY10 GDP data and the Industrial Outlook survey for Q2-FY10. This could alsomake a small contribution to GDP growth for the rest of the year.

It has maintained its GDP forecast of 6.4% for FY10, with a downward bias, for the reasons stated above: (1) There is lack of clarity on the winter crop; if it turns out to be good, it will redefine a floor for overall agricultural performance, as it has done previously. (2) Industrial activity continues to pick up. An improved investment outlook would further spur industrial growth. Any adverse drought-related impact is expected to come with a lag, and a negative base effect may then erodethe losses, especially in the final quarter of FY10. (3) The service sector should begin to feel the effects of higher fiscalexpenditure, the improved external situation, and the lagged effect of increased industrial activity.