With
the Sensex defying all laws of economic gravity, the
disconnect between India’s booming financial sector
and its real economy has only worsened. Few would
argue that the performance of the real economy can
explain the recent exuberance in the stock markets.
So, this may be a good time to look to the real economy
to introduce an element of moderation into assessments
of economic performance.
It hardly bears repeating that going by GDP estimates
(that are still subject to revision) the Indian economy
has moved on to a higher growth trajectory over the
last four years with growth averaging over 8 per cent
per annum. But what has been more welcome is the evidence
that high growth is no longer confined only to services,
but characterizes the manufacturing sector as well.
While agriculture still performs poorly, there appears
to be at least one segment of the commodity producing
economy that has begun to reflect the dynamism that
services have displayed thus far. And this trend is
continuing.
On October 12, the Central Statistical Organization
(CSO) released the provisional Index of Industrial
Production (IIP with 1999-2000 base) for the month
of August. This gave some cause to celebrate. Not
only was the annual month-to-month rate of growth
of the IIP (at 10.7 per cent) marginally better than
it was a year earlier, but it appears to have recovered
from a downturn in June and July this year, when industrial
growth lost some of its momentum and fell to 7.5 per
cent. These signs of the persistence of high industrial
and manufacturing growth are reassuring, since past
experience under liberalization suggests that high
industrial growth has not been the rule and periods
of high growth have been short-lived.
Taking a long view, we find that industrial growth
as captured by the IIP, which averaged 9 per cent
in the second half of the 1980s, slumped immediately
after the balance of payments crisis of 1991. However,
a recovery followed, with manufacturing growth rising
to a peak of 14.1 per cent over the three-year period
1993-94 to 1995-96. This led many to argue that liberalization
had begun to deliver in terms of industrial growth.
But the boom proved short-lived, and industry entered
a relatively long period of much slower growth, with
fears of an industrial recession being expressed by
2001-02.
Since then the industrial sector has once again recovered,
with rates of growth touching the high level s of
the mid-1990s by 2004-05. Even though the peak of
1995-96 has not been equaled, growth has been creditable
and sustained for more than three years now. But given
the mid-1990s experience every sign of a possible
downturn, as that in July this year, is received with
some apprehension.
Chart
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One
cause for comfort is that there are significant differences
between the mini-boom of the mid-1990s and what is
occurring now. As has been argued before in this column,
the 1993-1995 “mini-boom” was the result of a combination
of several once-for-all influences. Principal among
these was the release after liberalization of the
pent-up demand for a host of import-intensive manufactures,
which (because of liberalization) could be serviced
through domestic assembly or production using imported
inputs and components. Once that demand had been satisfied,
further growth had to be based on an expansion of
the domestic market or a surge in exports. Since neither
of these conditions was realized, industry entered
a phase of slow growth.
What was surprising, in fact, was that growth was
not even lower. Economic liberalization and fiscal
reform were bound to adversely affect manufacturing
growth. To start with, import liberalization resulted
in some displacement of existing domestic production
directly by imports and indirectly by new products
assembled domestically from imported inputs. Second,
the reduction in customs duties resorted to as part
of the import liberalization package and the direct
and indirect tax concessions that were provided to
the private sector to stimulate investment, led to
a decline in the tax-GDP ratio at the Centre by anywhere
between 1.5 to 2 percentage points of GDP. This implied
that so long as deficit-spending by the government
did not increase, the demand stimulus associated with
government expenditure would be lower than would have
otherwise been the case. Third, after 1993-94 the
government also chose to significantly curtail the
fiscal deficit as part of fiscal reform, so that the
stimulus provided to industrial growth by state expenditure
was substantially smaller than was the case in the
1980s.
Chart
2>> Click
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If
all this did not result in an even steeper decline
in industrial growth it was partly because increases
in consumer credit facilitated by financial liberalization
kept the demand for consumption goods at above average
levels in many years. Further, the ‘windfall gains’
registered by a significant number of central and
state government employees as a result of the payment
of arrears following of the implementation of the
Fifth Pay Commission’s recommendations also contributed
to an increase in the number having the wherewithal
to contribute to such demand.
Compared with that experience there are elements of
both continuity and change in the more recent boom
in manufacturing. The element of continuity stems
from the extremely important role that credit-financed
consumption and investment play in keeping industrial
demand at high levels. Credit has been an important
stimulus to industrial demand in three areas. First,
it has financed a boom in investment in housing and
real estate and spurred the growth in demand for construction
materials. Second, it has financed purchases of automobiles
and triggered an automobile boom. Finally it has contributed
to the expansion in demand for consumer durables.
The point to note is that compared to the mid-1990s
the growth of credit has been explosive, facilitated
in part by the liquidity injected into the system
by the large inflows of foreign financial capital
in the form of equity and debt. In the wake of this
increase in liquidity, expansion in credit provision
has been accompanied by an increase in the exposure
of the banking sector to the retail loan segment.
The share of personal loans in total bank credit has
almost doubled in recent years rising from 12.2 per
cent in 2001 to 22.2 per cent in 2005. Much of this
has been concentrated in housing finance, with housing
loans accounting for 53 per cent of retail loans in
2005. But purchasers of automobiles and consumer durables
have also received a fair share of credit. The importance
of credit-financed private consumption and investment
for growth has been flagged in recent times by the
Finance Ministry. Despite being an ardent votary of
financial liberalization and being committed to a
policy of minimal government intervention, it has
chosen to hector public sector banks into reducing
interest rates every time there is any sign of a slowing
of credit growth. It is not non-intervention that
the new breed of liberalization involves, but a form
of intervention that uses the financial sector as
means of stimulating the demand needed to keep private
sector growth going.
The element of change in the factors contributing
to industrial growth during the current boom as opposed
to that in the mid-1990s is the stimulus provided
by exports. In the early and mid-1990s high growth
was accompanied by high imports, with exports growing,
if at all, in areas where India was traditionally
strong. In recent years, the share of India’s traditional
manufactured exports such as textiles, gems and jewelry
and leather in the total exports of manufactures has
declined, while that of chemicals and engineering
goods has gone up significantly. This would have stimulated
growth. While exports are by no means the principal
drivers of manufacturing production, they play a part
in sectors like automobile parts and chemicals and
pharmaceuticals where Indian firms are increasingly
successful in global markets.
All this suggests that Indian industry has been experiencing
a transition. While during the first four decades
of development industrial growth was almost solely
dependent on the stimulus offered by government expenditure
and the support provided by public investment in infrastructure,
there are signs that other sources of demand such
as private consumption demand and exports are playing
an important role in recent times. Further, the current
industrial buoyancy suggests that these new stimuli
have, unlike during much of the 1990s, neutralized
the adverse effects that import liberalization and
fiscal contraction had on industrial growth. But with
just three years of high growth so far, the question
remains whether this is a sustainable trajectory or
merely another mini-boom awaiting its inevitable end.
The latter is a possibility if the growth in credit-financed
consumption or in exports is tenuous. To the extent
that the expansion in credit is dependent on the liquidity
generated by inflows of foreign capital, sustaining
the process requires the persistence of such inflows.
In the past a surge in capital flows has inevitably
been followed by a reversal, making this a real possibility.
Moreover, credit expansion has resulted in excess
exposure of Indian banks to the housing and real estate
sector, forcing the Reserve Bank of India to issue
periodic warnings. Defaults resulting from such exposure
would not only freeze credit flow, but could adversely
affect investor confidence resulting in an exit of
foreign investors.
Exports too are under threat because of the effect
that the surge in capital flows is having on the value
of the rupee. Exporters have been complaining for
long that rupee appreciation driven by capital inflows
is undermining their competitiveness making it most
unlikely that they would meet targets. But unwilling
to limit or curb capital inflows, the government has
offered to compensate them in other ways to neutralize
the effects of the appreciation. If it is not successful
in this effort the export stimulus may weaken too.
In sum, while there are important differences between
the mid-1990s industrial mini-boom and the boom that
is currently underway, which make this episode of
growth robust, the danger of a downturn still lurks.
This is a challenge the government must face up to.
That, however, may require shifting from credit to
state expenditure as a stimulus to growth and limiting
capital flows to stabilize the rupee.
