India’s near-term growth will be driven by higher consumption through lending rate cuts and hikes in central government employee pay, rather than capex or reforms, notes Bank of America Merrill Lynch.

Indranil Sen Gupta and Abhishek Gupta of BofAML in their June 1, 2015 research report in “India Economic Weekly” believe the Reserve Bank of India will cut 25 bp on June 2 and another 50 bp in early 2016.

BofAML trimmed India’s FY16 GDP forecast to 7.5%

According to the Bank of America analysts, despite headline March quarter GDP growth surprising to the upside at 7.5% due to a drop in subsidies, the gross value added (GVA) skidded to 6.1% from 6.8% in December and 8.4% in September.

Drop in India's GVA

The analysts note the recovery should be back-ended as lending rate cuts typically take six months to support growth. They anticipate GVA to pick up to 8.2% in March and 7.8% in December from 7% in December and 6.5% in June.

Indranil Sen Gupta and Abhishek Gupta note in the second half, economic growth should be aided by lending rate cuts boosting consumption demand and an improvement in earnings pushing up industrial production:

Divergence between GVA and GDP India

Moreover, investment also slipped to 33.1% of GDP from 33.7% in March 2014. On balance, the BoAML analysts have trimmed their FY 16 growth forecast marginally to 7.5% from 7.7%, slightly better than FY15’s 7.2%.

The analysts point out that the case for a 25 bp RBI rate cut on Tuesday has strengthened with GVA growth disappointing. (Note: As we write this piece, during Tuesday’s second bi-monthly Monetary Policy review, the Reserve Bank of India cut repo rate by 25 bps to 7.25%).

They also note inflation is well set on the RBI’s ‘under’ -6%, January 2016 chart, while real lending rates are at a peak since 1996.

Delayed recovery India

However, the Bank of America analysts believe the Reserve Bank of India Governor Rajan will likely pause in view of uncertainties surrounding the rains and Fed hikes that BofAML’s U.S. economists anticipate beginning in September. They note after the market prices the Fed in, the RBI will likely cut another 50 bp in early 2016:

India’s investment yet to pick up

Keep in mind that lead indicators continue to point to growth bottoming out very slowly. The following table highlights the schedule for a slow recovery:

Lead indicators India

The analysts also note that  real cash demand, a key indicator, continues to bottom out, while confidence is also improving with their (M1/M3) indicator picking up:

Falling risk aversion India

Indranil Sen Gupta and Abhishek Gupta note investment has slowed to 33.1% of GDP from 33.7% of GDP last year. They continue to believe that near-term growth will be driven by higher consumption rather than capex or reforms. They believe the boost in consumption should come from lending rate cuts, a hike in central government employee pay of 0.3-0.5% by the 7th Pay Commission and a possible increase in MSP for rice to 5-10% as highlighted by the Swaminathan formula before the early 2016 pools.

Investment yet to pick up India

Moreover, they argue that reforms can potentially push up GDP to close to 9% from the present 7-7.5%, although this might take 5 to 10 years to show up in the numbers.