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 1 >> Click to Enlarge
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 to Enlarge
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.