The surge in equity prices over the past few weeks has taken the major Indian stock indices close to their historic highs. Real estate prices have also been soaring. Inflation seems to have peaked, but is still very high by international standards. Is India overheating?
This column has earlier pointed out that the Indian economy shows signs of strain after a few quarters of high growth. The disturbing tendency to overheat at a very early stage in the economic cycle is an indication of underlying structural problems that need to be addressed with economic reforms. Barriers to investment ensure that supply tends to lag demand. The shortage of skilled labour pushes up wage costs faster than labour productivity. The government has few qualms about running pro-cyclical fiscal policy, boosting domestic demand when it should not be doing so.
Also Read Niranjan Rajadhyaksha’s earlier columns
Finance minister Pranab Mukherjee made the astonishing claim in Parliament in August that high inflation is the necessary price of high economic growth. This disingenuous claim does not hold when you look at the numbers. China has been growing at close to double digits for more than a decade; inflation has been either low or falling through most of these years, though there have been episodes of asset bubbles in that country. The point is that high growth is not necessarily accompanied by high inflation.
While prices of goods, services and assets need to be watched carefully in the coming months, India does not seem to have entered bubble territory right now. A comparison with the middle of 2007 is instructive. Those were the months when the signs of dangerous effervescence were most clear and the Reserve Bank of India had to slam the brakes. There seem to be fewer signs for worry right now.
Here’s a quick recap of some important economic indicators—then and now. The Indian economy grew by 9.7% in 2006-07 while it is likely to grow by 8.5% in the current fiscal. Inflation measured by wholesale prices was 7.5% in April 2007, and going up; it was 8.5% in August and southbound. Money supply was shooting up at 21.7% at the end of April 2007 while M3 growth is a more muted 15.1% in the fortnight ended 27 August. Growth in non-food bank credit was accelerating at 28.5% at the end of fiscal 2007 while it is currently growing at less than 20%.
In short, the Indian economy is growing at a slower pace right now, perhaps closer to its sustainable trajectory; money supply and bank credit growth is more muted; and inflation —though still intolerably high—seems to be coming off its recent highs. Overall monetary conditions are now in the restrictive territory, according to a recent note by Nomura India economists Sonal Varma and Ketaki Sharma, who use a weighted average of the real effective exchange rate and real policy rates to assess the tightness or looseness of monetary policy. These are not signs of an economy in the midst of a credit bubble.
Judging whether stocks and real estate are in bubble territory is always a tough call, but a recent analysis published in this newspaper on Monday shows that the percentage of market capitalization to gross domestic product (GDP) is down from 160% in January 2008 to an estimated 104% right now, based on an assumption of 8.5% economic growth in this fiscal year. In other words, the underlying economy has grown faster than the market value of listed equities in these past 30 months or so. Similarly, real estate prices seem to be at historic highs, but the ratio of housing prices to average incomes is lower today than it was two or three years ago.
The main macroeconomic risks right now are elsewhere—the twin internal and external deficits. India ended 2006-07 with a current account deficit of 1.1% of GDP. This year the external deficit could be anything between 2.5% and 3% of GDP, one of the highest levels since the crisis of 1991. Government profligacy has eaten into national savings and led to a wider current account deficit (or the gap between domestic investment and domestic savings), which makes India heavily dependent on capital inflows at a time when the world economy continues to be fragile.
Fiscal policy is way too loose at this juncture, and the Manmohan Singh government seems to have blown away the windfall it received from the sale of spectrum for third-generation telecom and broadband wireless. The government went to Parliament in August, seeking permission to spend an extra Rs 55,000 crore for various schemes. It seems very likely that the government will just about meet its budgeted fiscal deficit target despite getting Rs 1 trillion on a platter.
The major economic risks are not from an asset bubble, but from the growing fiscal and current account deficits.
Niranjan Rajadhyaksha is managing editor of Mint. Your comments are welcome at firstname.lastname@example.org