Reading the recovery

Indian Express, 3 February 2010

Last week RBI announced its credit policy. Later this month, Finance Minister, Pranab Mukherjee, will announce the Union Budget. The withdrawal of the monetary stimulus has been limited to reversing some of the steps taken after the global financial crisis hit India. The steps taken in the credit policy announcement of last week were not harsh. They indicate that the withdrawal of the fiscal stimulus is also likely to be cautious. Sharp hikes in tax rates are not likely. Some expenditure reduction will happen and the fiscal deficit number should be lower.

Governor Subbarao's credit policy announcement was cautious in its approach. Even though the RBI raised its growth and inflation forecasts significantly, it did not raise interest rates, fearing that 'the recovery is yet to fully take hold' and that 'strong anti-inflationary measures (would deter) private investment and consumer spending.'

Quick estimates released by the CSO offer an insight into the reasons for this concern. In 2007-08, the investment to GDP ratio in India was 38.2 percent. The sharp rise in this ratio since 2002 was the prime engine of growth of the Indian economy. In 2008-09, the investment to GDP ratio fell to 34.9 percent. The sharp decline can be attributed mainly to the decline in private investment.

The boom period of 2002 to 2007 saw a sharp rise in private corporate investment as a share of GDP from nearly 5 percent to 15 percent. It contributed to the upswing in the business cycle in India more than any other factor. The global financial crisis brought the investment boom to an end. Since investment depends upon animal spirits and expectations of investors, it will pick up slowly as the enviroment improves. For the year 2008-09 for which CSO's quick estimates have been released, private corporate investment as a share of GDP fell from 15 in 2007-08 to 13 percent.

Investment in construction and manufacturing were the hardest hit. India witnessed a steep decline in the growth of investment in manufacturing. Gross capital formation in manufacturing actually declined, falling by 16.5 percent compared to the previous year. For construction, the decline was even sharper at 18.5 percent.

The other component of investment is inventories or stocks. Estimates for the decline in inventories offer an interesting insight into the impact of the crisis. The data for 2008-09 shows an unprecedented fall in inventories. In aggregate, stocks fell to nearly half of the previous year. This decline was in the private sector where stocks in the private corporate sector fell to nearly a fifth and in the household sector to a tenth of the previous year's levels.

This decline was part of the reason for the decline in manufacturing growth to merely 1.5 percent in 2008-09. The uncertaintly in the market, global conditions, export contraction and the liquidity crunch in bank and non-bank financial institutions were among the factors that caused the sharp decline in inventories. Further, the pick up in manufacturing production seen in the following months, such as in June 2009, can be explained, as in the US also, by an increase in inventories by firms. After inventory depletion in 2008-09, firms produced more to rebuild stocks as they expected consumer demand to recover.

Thus estimates for private investment and investment in manufacturing suggest that there is still enough cause for concern. The contribution of public sector consumption has been keeping the GDP growth rate high. The sixth pay commission, the farmer loan debt waiver and the increase in spending on the rural employment scheme appear to have provided the stimulus needed for the economy to keep demand from falling sharply. Government final consumption expenditure suddenly jumped to 26.7 per annum, much higher than the growth in the previous years which generally ranged from 10 to 16 percent. This was the stimulus that kept the economy going.

What could the stance of fiscal and monetary policy in the above environment be? Policy makers are likely to be inclined to step very gingerly. If monetary tightening worsens the investment environment the industrial growth will be high. In the credit policy announcement, RBI lowered its expecation for growth in non-food credit growth from 18 percent to 16 percent. This is not an environment to tighten policy. Another reason not to raise interest rates is that such a move is unlikely to control inflation unless there is huge increase in rates. Further, much of the inflation is caused by a rise in food prices. Considering that, it would be unwise to raise rates as that would not be effective as an anti-inflation tool.

Political compulsions add to the reasons for not withdrawing the fiscal stimulus suddenly. Government administrative expenditure, higher salaries, education spending, subsidies and interest payments often take on a life of their own and once they have been initiated, are very difficult to kill. Tax revenue growth will not rise unless industry picks up seriously. The government will have to rely on disinvestment numbers to get a lower number for fiscal deficit. Also, the change in the GDP base year implemented by CSO last week, which makes the denominator bigger will help make the deficit ratio smaller.

While there may be some upward tweaking of tax rates which were lowered in response to the crisis, and there may be steps consistent with the direct tax code, the total impact of those changes in terms of higher tax revenue raising may be limited. The finance minister will have to walk a tight rope walk since high governmetn borrowing will keep the cost of borrowing for the private sector high as well, which could crowd out private investment. All said, Pranab Mukherjee is unlikely to take the risk posed by a large withdrawal of the stimulus, even if it was politically feasible.

Back up to Ila Patnaik's media page
Back up to Ila Patnaik's home page