The Hindu Business Line : The industrial downturn

While the stock market seems to have temporarily weathered the global downturn, its adverse effects on the real economy are now intensifying. To examine how and why, C. P. Chandrasekhar and Jayati Ghosh assess the immediate and long-term implications of recently released figures on industrial growth.

— S. R. Raghunathan

An assessment of industrial growth shows that the impact of liberalisation is much less creditable than otherwise assumed.

Even as India’s stock markets are staging a recovery from the depths they have mined, disconcerting news emerges from elsewhere in the economy regarding the effects of the global crisis. The two main channels through which the global crisis is being transmitted to India are a decline in exports and a net outflow of foreign investment.

Declining export values

Figures for the dollar value of exports during the month of March 2009, point to a 33.3 per cent decline in export values relative to the corresponding month of the previous year. This is the fifth consecutive month in which the month-on-month growth rate has been negative, and the one in which the fall in exports has been the largest.

India’s exports over financial year 2008-09 stood at $168.70 billion which was just 3.4 per cent higher than in 2007-08. This compares with 23-31 per cent annual growth rates over the previous four years. Given the structure of India’s exports, it is to be expected that this deceleration in export growth would have affected output growth in a range of traditional and modern manufacturing sectors that have contributed to the export revival of recent years.

The other area where the effect of the crisis is visible is capital inflows. With foreign investors having to reduce their credit dependence and meet commitments at home, they have been booking profits or selling assets in emerging markets to mobilise the requisite funds. This affected India as well during the last financial year.

As compared with a net inflow of portfolio investment of $29.4 billion in 2007-08, India experienced a net portfolio investment outflow of $13.9 billion in 2008-09. Though direct investment inflows remained high at $33.6 billion, they were lower than the $34.4 billion recorded in 2007-08, resulting in a total net foreign investment inflow of just $19.6 billion in 2008-09 compared with $63.8 billion in 2007-08.

Even though there has been a sharp increase in FII inflows in recent weeks, there is reason to believe that such inflows are the result of speculative allocational decisions across geographies on the part of investors with limited funds. Since they reflect attempts to squeeze out as much as possible from still-tepid global markets, such flows are potentially extremely volatile.

Finally, a third disconcerting feature of the emerging economic scenario is the evidence on industrial growth. The month-on-month annualised rate of growth of industry, as reflected by the index of industrial production, points to a sharp deceleration and subsequent contraction of output in the organised industrial sector.

As Chart 1 shows, month-on-month rates, which indicated a slackening of industrial growth during the first two quarters of 2008-09, point to significant worsening of industrial performance leading to negative growth rates during the subsequent two quarters.

Domestic demand

While the export decline noted above could partly explain this adverse turn, the substantial dependence of Indian manufacturing on the domestic as opposed to the export market implies that the fundamental problem facing the economy is a slackening of domestic demand. This domestic demand recession is surprising for a number of reasons.

First, even though the government’s crisis-induced effort at providing a fiscal and overall demand stimulus to the economy remained half-hearted, that effort came on top of the fortuitous stimulus provided by the implementation of the Sixth Pay Commission’s recommendations, which included the payment of arrears that offered windfall gains to domestic consumers.

Since, the beneficiaries of the Pay Commission’s recommendations fall in the middle and upper-middle class categories, it is to be expected that their windfall gains and higher salaries would be directed towards demands for manufactures, besides luxury services. If despite that industrial growth has been indifferent or poor other factors must have neutralised the effects of this fortuitous stimulus.

Second, the effects of the crisis have been transmitted to India precisely at the time when the political business cycle would have worked to drive up economic growth. The general election would have substantially increased spending in various forms. Not only would government expenditures been higher on average as incumbent governments sought to push ahead with programmes and concessions to win over the electorate, the recorded and unrecorded expenditures undertaken by the Election Commission on the one hand and the political parties and candidates contesting the elections on the other would have injected additional demand into the system. This too seems to have been inadequate to stall a recession.

While it is undoubtedly true that if these fortuitous stimuli had not played a role, the manufacturing recession would have been even deeper than revealed by the extant numbers, the element of surprise is that those stimuli have not been able to prevent the downturn.

The effects of the global recession are much stronger than expected. This in turn implies that all earlier talk of India being decoupled from the international system was completely unfounded. One reason is that, besides India’s integration with the global system through the exports of manufactures that have been on the decline, the other form of integration and mechanism for transmission of the effects of the global recession to the country is the export of services.

Even though there has been a lag in the transmission of such effects, the fact that more than 60 per cent of India’s software and IT-enabled exports are directed to US markets and that the financial services industry there accounts for a large part of this business has meant that the effects financial crisis and economic recession were bound to be felt sooner than later.

The second-order effects of that impact and consequent loss of employment in services is partly visible in the form of a contraction of industrial demand.

Portfolio capital

The other important means through which the global crisis is possibly affecting India is through the reversal of portfolio capital flows to the country, which had been massive during the period of the high, near-9 per cent growth it experienced over almost five years.

The immediate impact of that reversal was a collapse of the stock market boom and a depreciation of the rupee. The first of these could have had wealth effects that affected demand adversely, besides having created cash flow problems for a number of entities.

If, for example, a firm had borrowed against securities, the fall in the value of collateral would have given rise to calls that would have stretched their resources. The other side of this is the greater difficulty firms would face in accessing credit.

The depreciation of the rupee, on the other hand, would have increased the rupee costs borne by firms and agents who had borrowed from the international market in the past and had to meet interest and amortisation commitments in foreign exchange. Given the sharp increase in private external commercial borrowing in recent years, this too would have stretched available resources, affecting demand and production and even threatening bankruptcy.

Finally, all of this would have also affected the state of liquidity in the system and more importantly the willingness of banks to lend. This would not only have impacted adversely on firms, but also on credit-financed housing investment, automobile purchases and consumption.

These credit-financed sources of demand had expanded significantly in recent years, with advances for such purposes having increased sharply in absolute terms and as a share of total advances. Hence, the credit retreat (rather than squeeze) would have played an important role in triggering the recession.

Larger lessons

This experience has a larger lesson about the effects of liberalisation on manufacturing growth in India. Originally it was expected that trade and industrial policy liberalisation in India would result in a restructuring of manufacturing production that would increase India’s presence in global markets.

Domestic firms subjected to global competition were expected to restructure and establish best-practice capacities at internationally competitive scales, making them successful in international markets. On the other hand, the liberalisation of the rules and terms for entry of foreign firms were expected to encourage international firms to locate in India for world market production.

Together this was expected to make global rather than domestic demand the principal stimulus for manufacturing growth. Indeed, this is what happened in the Chinese case.

In India, on the other hand, while liberalisation did change the sources and pattern of growth, this was not because of a shift in favour of an export-based stimulus, but because of the expansion of new sources of credit-financed consumption that widened the demand and market for manufactures goods. What the current crisis has done is to challenge the sustainability of that form of growth.

In the event, if we undertake a medium- or long-term assessment of industrial growth, the impact of liberalisation seems much less creditable than otherwise assumed. It is well known that after the balance of payments crisis of 1991 and the import-compression influenced contraction of manufacturing production in the early 1990s, the recovery of industrial growth began in 1993-94.

That is the year which constitutes the base for the revised series of Indices of Industrial Production that is still in use. We therefore have a consistent data set on trends in industrial production as revealed by this lead indicator since 1994-95.

Examining the month-on-month growth rate since April 1994-95 (Chart 2), we find that industry experienced a mini-boom during 1993-94 to 1995-96 when month-on-month growth rates went as high as 18 per cent.

However, 1996-97 witnessed a sharp downturn in industrial performance, after which industrial growth remained indifferent or poor for a long period stretching till the middle of 2003. A second boom occurred thereafter lasting till the end of 2006, when once again month-on-month manufacturing growth exceeded 17 per cent, though it was still short of the previous September 1995 peak. Starting early 2007, however, we have been once again witnessing a downturn, with rates now touching the negative lows we observe for March 2009.

In sum, if we take a long view, industrial and manufacturing growth rates have not been spectacular or even excessively creditable during the years of liberalisation or “economic reform”. That period has largely seen indifferent or poor industrial performance broken by two short booms. This comes through quite clearly also from the year-on-year growth rates recorded since 1994-95 as revealed by the annual IIP figures (Chart 3).

This is not because liberalisation did not influence the sources and patterns of growth. It did. But its ability to trigger high growth was sporadic and limited because such growth clearly came from sources which were not sustainable.

Related Stories:
Exports plunge 33% in March
Industrial output contracts 2.3% in March; poor show by manufacturing

More Stories on : Economy | Exports & Imports | Foreign Direct Investment | Macro Scan

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page