Taking Stock of the Indian Economy

All infection spreads, and economic sentiment is infectious. When things go well, it is perhaps but human nature to push the downside out of the way. And so is the opposite case when things start not doing so well, prospects begin to look sour and the future dire – and the transition can be surprisingly quick. The US sub-prime business broke out into the public gaze back in August 2007, but markets after an initial jolt were buoyed by their general optimism that this storm will be weathered, even if a few banks, financial investors and myriad homeowners get hit. However, since the beginning of January 2008, with every talking head calling recession and the highest policy makers in the US appearing to act on that premise, the game has turned: For the worse.

If I was a policy maker in the US it is easy to see that in the near future there look to be only two possible outcomes: (a) A slowdown or a mild recession; or (b) A serious recession. It I operate on the principle that it is (b) and then proceed to provide hundreds of billions of dollars of tax relief and opt for an unprecedented slashing of interest rates – there is no way that I can be faulted. If (a) is the outcome, I can claim that I “beat the recession”. If it is (b) that happens, I can claim that “I did my very best”. Heads I win, tails someone else loses. The only problem is that by opting for this ultimate policy hedge, there is a possibility that a recession may actually make the visit, when there need not have been such a visitation.

Some macro-economic outcomes, especially short term ones, are directly dependent on how individual economic agents view that short-term. The US economy is squishy and unwell, what with all those home loans going belly up and hundreds upon thousands of people losing their homes to foreclosure and with big banks and insurance companies in financial difficulties. In such a climate, by undermining confidence, which is precisely what this one-sided take on recession amounts to, it is conceivable that the economy can be tipped unwittingly on to the path that leads to recession. Or may be not so unwittingly, many may submit – these are after all big boys and they know what they are doing.

In a globalised and increasingly integrated world, what happens in one part of the globe affects others – especially if it is the world’s largest economy where the troubles are. Asian markets have suffered because of the linkages that these economies have with the huge exports that cross the Pacific and the related interconnections within these Asian economies. Europe has been watching the developments across the Atlantic with considerable alarm, and huge financial losses one may add, and they are worried of the fallout.

India is a bit different in the sense that much less of its economy is driven by the growth of consumer expenditures in the USA. However, when everyone catches the flu, it is tough not to be affected. Further there have been certain things that have been happening purely in the domestic context. Many are seeing a GDP growth of 8.7% in 2007/08, down from 9.6% in the last year, as evidence that there is a slowdown of economic activity at home as well. The more recent release of industrial production data, which is down to 7.6% in December 2007 from double-digit figures last year, is being viewed as further evidence. Export growth has also slowed through much of the current fiscal. Many prescribe a cut in interest rates, others suggest fiscal stimulus.

It is indeed curious to see this reaction, considering that till just a few years ago, sustaining growth above 6% was so tough. It is curious that the idea that may be the sustainable rate of growth of the Indian economy could perhaps be 8.5% or 8.0% or perhaps even a bit lower and not 9.6%, should be so alien to so many. With “core” (excluding food and energy) inflation at 4.7% at the end of January 2008, surely it is not exactly a paucity of demand that has brought about lower rates of growth to industry and the rest of the economy. The problem is not demand – it is that old perennial albatross around our neck – supply.

Look at electricity generation. Power utilities had added 6,485 MW of additional capacity in the first nine months of 2007/08, as much as 77% more than in the same period of 2006/07. Power generation in 2007/08 up to 11 Feb 2008 was 99.6% of that programmed at the beginning of the year. Despite that we know that power outages continue and generation by utilities in December 2007 was barely 4% more than in the same month of last year. The plain fact is that the rate of capacity addition is not good enough. In fact the shortfall in capacity addition up to December was 50% of that programmed for 2007/08. We just have to push the system to believe that the economy is growing much faster than they are used to, that huge unmet demand is out there, and we have to add much more generating capacity each year.

Inadequate capacity creation also seems to be the problem in parts of the private sector. In cement, only 9 million tonnes of capacity was added between January 2007 and January 2008. Little surprise that output growth was just 3.7% in December 2007 and 5.0% in January 2008. One may note that capacity utilisation in January 2008 was 102%. I am not sure what is happening in steel making and some other sectors were output growth has been quite low in recent months, but capacity constraints may be the problem. These are all “basic” goods which registered 5.2% and 3.1% output growth in November and December 2007 IIP index and have played a major part in pulling the IIP down.

Now, let us go back to demand. The Advance Estimates for 2007/08 tell us that the Investment Rate as a proportion of GDP rose to 38.5%, up from 35.9% last year. The Savings Rate was probably a bit over 37%. Real consumption growth was slower in 2007/08 at 6.6% compared to 7.0% and 7.9% in the preceding years, while real fixed investment growth was nearly 16%, up from 15% in 2006/07 though slightly lower than in the two preceding years. In 2007/08 as much as 5.5 percentage points of the overall 8.7% growth has come from investment demand. What these numbers tell us is of an enormous investment boom driving the economy forward. However, several large parts of the economy are not yet being able to keep pace – electricity and cement are two that we have seen – and when that happens, things can and do slow down a bit. The appropriate response is to press the right buttons to get the slower parts to move faster and keep preserve the momentum of advancement that our economy is experiencing. And keep business and consumer confidence up. Instead of falling for the stimulus red herring and undermine our achievement in strengthening the basic macroeconomic parameters – in regard to inflation and the fiscal deficit.

(The author is Economic Advisor, ICRA)

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Published in Mail Today, Thursday, 14 Feb 2008