Riding the cycle

Business Standard, 2 June 2004

Last week, the Conference Board of New York and the Singapore Statistical Department organised a seminar in Singapore on the state of economic indicators and business cycles in Asia. Participants from China, India and ASEAN countries reported on the current state of research in their countries.

The subject of business cycles in Asia has started attracting attention. Asian growth is now the envy of the world, and an increasing proportion of world GDP growth comes out of Asia. The Asian crisis revealed the global impact of economic fluctuations in India. So there is heightened interest in business cycles in Asia.

The biggest bottleneck to doing high quality work in this field is that of the statistical system. In general, most of the data that is used in OECD countries, for tracking and predicting business cycles, is not even collected in poor countries.

For example, the most important series used to examine business cycles in the US are monthly data for unemployment, hours worked, and wages. None of this data exists in India. Unemployment data from the NSS becomes available in India every five years. The latest year for which data is now available is 1999-2000. And most scholars would exercise caution in using NSS data to aggregate up to macroeconomics.

More importantly, there are serious conceptual issues which come in the way. An examination of the output series suggests that India has witnessed six recessions in the last 50 years. But all the recessions before the 1990s were a consequence of exogenous shocks. These were mainly the failure of the rains which lead to a decline in output. In the 1970s, the oil price shocks exacerbated the impact of bad monsoons.

These ups and downs were driven by external shocks and not by endogenous factors. As Victor Zarnowitz, one of the fathers of modern business cycle research, pointed out in his keynote address, business cycles are a phenomenon of modern industrial market economies. You do not expect business cycles in medieval economies. In a market economy, investment in plant, equipment and inventory is more prone to cyclical behaviour than consumption. In general consumption is far smoother. As the scale of investment is far larger in industrial economies, they witness periods of over-investment and adjustment that create business cycles. Cycles arise as investment decisions respond to changes in aggregate demand.

Industry accounts for less than 25 percent of output in the Indian GDP. In the pre-reform period a large share of this has been in the public sector where investment decisions were driven more by the planning process than by the market. In addition, because of the industrial licensing regime, investment in new factories or even expansion of existing capacity was not market driven. Other than investment in inventories, investment in the formal industrial sector was supply constrained.

It was only in the informal sector, which is the only truly free market capitalism India has had for the last 50 years, that investment decisions were highly responsive to the demand conditions in the market. Apart from the informal sector, in most parts of the economy, we did not have active decisions from year to year about investment and about building up capacity. In this sense, it is wrong to apply the word "business cycle" to the traditional ups and downs of the Indian economy.

The liberalisation of the economy in the 1990s has changed all this. We are now witnessing a much larger market driven investment process. We are now seeing cycles in the buildup and drawdown of inventory which look like those found in a market economy.

It is important to accept that all market economies witness business cycles. The cycles may be long or short, but when growth rates increase, at some point, the increase becomes unsustainable and a slowdown sets in. While there is no doubt that the Indian economy will be amongst the fastest growing economies in the world, there should also be no doubt that this will not be growth at a steady, unvarying rate. The economy will definitely witness growth rate cycles (cycles in growth rates) even if there is no absolute decline in output.

As an example, consider the period after 1993. At first, there was great optimism. P/E ratios rose. Corporate earnings soared, and there was an investment boom. After this phase, when the economy slowed, firms initially cut investment, and built up inventory to avoid disrupting production planning. After this, investment stayed at resolutely low levels, while inventory drawdown took place. Losses were experienced, and weak firms started dying. It is such ups and downs that the industrial economies call "the business cycle".

In terms of data availability also the 1990s saw an improvement. Once we think about the business cycle in terms of the behaviour of firms of India, we can turn to exploiting the CMIE database which gives us quarterly and annual time-series about the firms of India. India fares well, when compared with other countries, in the quality of this database. An analysis of the aggregate level of sales, profits, investment and gross value added of all companies reveals behviour similar to that observed in industrial market economies. This micro data is thus a valuable new resource for understanding Indian macroeconomics.

The Indian economy is not only increasingly driven by domestic market forces, it is also getting more and more integrated into the world economy. Today exports of goods alone are over 10 percent of GDP, and services exports are also substantial. As Pami Dua has demonstrated, the performance of Indian exports depends on the business cycle of developed countries. As a result we should expect to see business cycles in US and the rest of the world getting transmitted to India.

This perspective has major implications for macro policy making in India. Until now the main objective of fiscal and monetary policy in India was to push growth. With the expectation of far greater cyclical behaviour in the economy, we need to learn to do counter-cyclical fiscal and monetary policy.

A government with its back against the wall in terms of fiscal problems will endup exacerbating the business cycle. What is needed is to spend more and earn less in a bad year. Instead, a fiscally strapped government will spend more in a good year (like 2003-04) when faced with buoyant tax revenues and less in a bad year (like 2002-03). This aspect is a powerful reason in favour of fiscal consolidation, so as to set the stage for a potent counter-cyclical fiscal policy.

The success of counter-cyclical monetary and fiscal policies in the US in recent years has also heightened awareness of the need for an independent monetary policy. In recent years, India has considerably given up monetary policy autonomy in favour of currency market manipulation. This tradeoff needs to be questioned in the light of the role that is desirable for monetary policy in managing the business cycle.

Finally, both fiscal and monetary policy can be effective in smoothing business cycles when policy makers have better information and analysis of business cycles in India. While there has been some research in this field in India such as at NCAER, RBI and DSE, it is still in its incepient stages. For more effective policy making there is a need for improving collection of data, monitoring and analysis of the emerging cyclical behaviour of the Indian economy.

The author is at NCAER. These are her personal views.

Ila Patnaik

Ila Patnaik
ipatnaik at ncaer dot org