Car sales in May grew at their lowest rate in two years. Dealers are seeing inventories pile up. Manufacturers have begun to offer freebies to consumers as high inflation, climbing interest rates, more expensive fuel and general economic uncertainty bite into demand.
Are these signs that the economic slowdown will get worse in the months ahead, as the Reserve Bank of India (RBI) pushes up the cost of money to battle inflation? Industry is definitely worried. A day before the Indian central bank hiked its key policy rates for the 10th time in 15 months, business lobby group Federation of Indian Chambers of Commerce and Industry warned in a public statement that higher interest rates have already begun to hurt.
The new industrial outlook survey conducted by RBI catches some of these fears in a snapshot of numbers. It is clear from the details that Indian manufacturing companies see a cloudy future, be it in terms of lower demand, higher inventories, less employment or foreign trade.
These gloomy expectations do not fit well with what the macroeconomic data tells us. Other than car and commercial vehicles sales, other leading indicators such as bank credit, non-oil imports, and railway freight do not—as yet—indicate anything more than a modest slowdown.
Capital goods production, which is a proxy for investment activity, continues to be a puzzle. The old Index of Industrial Production (IIP) showed slowing machinery production despite mind-boggling volatility in the monthly data. The new IIP, introduced for April with a new base, presents a brighter picture of investment activity. To add to the confusion, gross domestic product (GDP) data for the fourth quarter of fiscal 2011 indicates that capital expenditure has stagnated.
It is thus quite likely that the Indian economy needs to see more demand destruction before inflation comes back into safe territory. RBI is expected to raise its policy rates by at least another 75 basis points by December, though even that would leave short-term interest rates lower than where they were at their peak in July 2008, a few weeks before the financial crisis erupted.
The Indian central bank has done most of the heavy lifting in the ongoing battle against inflation. The government continues to run a loose fiscal policy, in effect spending away in an economy that is already feeling the pressure of excess demand. Neither has it taken any concrete steps to raise the productive capacity of the economy. Economic reforms have stalled since 2004.
A tight fiscal policy would help tackle the cyclical component of the current surge in inflation while a fresh dose of economic reforms would help deal with the structural component.
Finally, how more pain is left? It is always tough to assess the trade-off between growth and inflation. In its 2002 Report on Currency and Finance, RBI had estimated that India would need to sacrifice two percentage points of growth for every 1 percentage point drop in inflation. That is a large cost, more than one standard deviation of the average growth in 28 quarters since fiscal 2004.
A small excursion into historical data is a sobering exercise as well.
Fiscal 2011 was just one of five instances in over five decades when India’s nominal GDP expanded by more than 19%. Nominal GDP is the addition of output growth and inflation.
In all previous instances, bringing nominal GDP growth back to trend through demand compression led to painful slowdowns within the next year or two; 1957, 1981 and 1989 also led to balance of payments scares. The other year with high nominal GDP growth was 1974.
India is not headed for a similar train wreck. But below-par growth in the next year or two could not only hurt industry, but also impair public finances.
The finance ministry has already hinted that tax collections this fiscal may not meet the budgeted figure, which means that the fiscal deficit target will also not be met, especially since there are no telecom auction bonanzas this year to bail the government out.
There could be longer-term costs as well. “Stress tests show that only a modest decline in growth (say to about 6.5%) or a few percentage points rise in real interest rate (to around 3% from the current 0%) could put the debt trajectory in jeopardy, requiring substantial fiscal adjustment,” wrote Deutsche Bank AG economists Taimur Baig and Kaushik Das in a recent note.
Two years ago, everyone from senior policy makers to investment bankers seemed to believe that sustained double-digit growth was there for the asking and that the initial jump in inflation was a temporary worry that would be washed away with a good monsoon.
As is now evident, the exuberance was ill-timed. The combination of an economic slowdown and stubbornly high inflation has been like a splash of cold water in the face.
Next: Anil Padmanabhan on policymaking.