Position today

Data was recently released on the performance of the Indian economy in the first quarter of 2008-09, placing GDP growth at 7.9%. This is 1.3 percentage points lower than Q1of 2007-08, and a source of concern given the urgency of rapid economic growth in eliminating poverty. A major cause of the slowdown has been the industry sector, particularly manufacturing. The question is how much lower can GDP growth go, and how long will it take for growth to revive to the 9-plus percent of the last three years.

In the last month or so, we have seen a number of forecasts on the Indian economy, including from the Reserve Bank of India, the Economic Advisory Council, international banks and think tanks. Most of them believe that GDP growth for the year will end at around 7.5%, more than a percentage point lower than last year. As the fiscal year has progressed, a sense of impending doom seems to have pervaded the country. Marginal decline in the rate of inflation, recent descent of oil and commodity prices, and USA’s strong Q2 GDP growth at 3.3% have not eased pessimism either.

Often, gloomy forecasts tend to be self-fulfilling prophecies, impacting investment decisions and economic policies. Therefore it is all the more urgent to present the bright side of the picture. To begin with, with industrial and economic statistics at the current incomplete stage, Q1 GDP may well be understated and could be revised up to as much as 8.2%. I am confident that this higher estimate will prevail. Here’s why.

The investment to GDP ratio came in at a high of 37.4% in 2007-08, and the Economic Advisory Council expects this to be retained at around the same level. This had brought us GDP of 9% in 2007-08, and the capital efficiency of the economy is unlikely to drop drastically from one year to the next. Even assuming a fall in investment arising from higher interest rates, this should not dent the growth rate to below the 8% level.

There are huge demand injections coming into the economy from increased Government expenditures on NREGS, loan waiver, and Sixth Pay Commission award. These are likely to boost the sagging consumer durables sector. All eyes will be on the festival season, coming early this year.

The services sector has continued to perform well in the first quarter. This is an area that is somewhat immune to poor infrastructure, lack of adequate power and incomplete physical connectivity. The sector now comprises over 55% of the GDP, and its continued performance can help preserve the growth momentum.

Corporates are maintaining the pipeline of investments of $700 billion over the next three years in projects already committed. CMIE’s data also reveals that corporate investments are robust, with announcements of fresh investments at $117 billion in the first quarter of FY09. In July alone, $45 billion of new projects were noted, as compared to the monthly average of $33 billion last year. As per the CSO data, bank credit expanded by 25.8% in Q1. There is no liquidity crunch in the Indian financial system, and banks are ready to lend. Non-food credit to the commercial sector went up by 25.9% in the first week of July compared to 24.6% in the same period last year.

FDI inflow has also been very healthy, although FIIs have reversed the earlier positive flow. For the first quarter, FDI of over $10 billion came into the country, as compared to $25 billion in the whole of 2007-08. Indian companies are also sourcing funds overseas at lower costs. As per RBI figures, ECB in 2007-08 was 54% more than the previous year, while equity raised through ADR/GDR in Q1 FY 09 was three times that in Q1 of last year.

Rural demand remains strong, buoyed by excellent agricultural performance last fiscal and continued growth in Q1. Sowing in the kharif season came in at 1.3 million hectares more than the corresponding period last year. High global rice prices have boosted area under rice cultivation. The weakening of the monsoons in the last month might impact agricultural growth, but demand in villages is not expected to slacken.

Export performance continues to be robust. It is likely that as overseas banks cut costs, they will turn increasingly to cheaper outsourcing, and India has proven strengths in financial software services. In the goods market, global downturn could mean shifting of price preferences to more competitive sources and India should take advantage of this.

There are indications that economic activity might pick up in the remaining three quarters. A big boost has been the performance of the US economy in the second quarter, which might point to a faster recovery from recession than expected, although employment figures are still of concern. US growth has been driven by exports, which in turn arose from the declining value of the dollar. However, the dollar is again strengthening against major currencies, particularly the Euro, and implications for the US recession are uncertain. US pain has been felt globally with major economies experiencing slower growth, but it is widely believed that recession will last only through this year.

For India, a falling rupee means more goods and services are exported. At the same time, commodity prices have also moderated, particularly oil. Analysts, who just a few months ago were talking about $200 per barrel prices, are now pointing to the global economic downturn as a reason for oil prices to come down below $100. These developments are good news for India, and once the effects of the monsoon become clearer, we can expect inflation to come down and growth to resume at the earlier level.

Inflation remains the key threat to the economy at well over 12%. Tolerance for price rise is low in India, although CPI is estimated to be below double-digit rates. Interest rate hikes since 2006 have helped limit the upward spiral, as compared to other countries which have been facing much higher inflation rates. Responses to inflation have varied across the globe; weaker growth and slowing inflation have prompted many central banks – Australia, Eurozone, and Canada - to consider maintaining their interest rates unchanged this month. In India however RBI is likely to continue raising rates this year.

This would further put the lid on GDP growth, and would definitely hit future investment plans. Interest cost rise coupled with higher input costs and demand deceleration are acting as major brakes to incremental investments. So far, industry has been able to deal with rising cost pressures through improvements in factor productivity, driven by innovations. However, if interest rates continue to be hiked and returns to investment drift downwards, industry may be constrained to review fresh investment plans.

The higher rates of inflation call for rapid response measures in other areas such as alleviating supply chain bottlenecks. The persistence of supply chasms in power, transport, mining, etc. adds tremendously to inflationary pressures. Reforms to increase agricultural productivity, improve PPP in infrastructure, boost the mining sector, and better the investment climate are sorely needed. Some measures can be taken rapidly for immediate results – for example, increasing ECB limits - while others would take time to play out. Overall, though, such measures would reduce transaction times and costs across the economy and raise competitiveness with respect to the global economy.

Another source of concern is the pressure on the fiscal performance of the Government. Although tax revenues are still buoyant, hidden Government expenses are expected to push the fiscal deficit to as high as 7-8% and higher if deficits of state governments are added. Oil under-recoveries to the tune of Rs. 200,000 crores and issuance of bonds of up to half that amount can crowd out funds in the long run. This would negatively impact infrastructure financing with long time horizons. The solution lies in hefty additions to the consumer prices for petroleum and products, a politically and socially sensitive move. Government would have to weigh long-term costs of oil subsidies to future prices and growth against possible social unrest and inflationary pain in the short-term. There are no easy answers.

After five years of heady growth, we are potentially in a crunch situation. Tough decisions will have to be made at all levels – government, industry, consumers – and some belt-tightening might be in order. While there are pressures on top- and bottom-lines, India’s growth trajectory cannot but remain steeply upward bound as 1.1 billion people aspire to a better future.