The Puzzle
A prominent feature of the Indian economy in 1996-97 was the contradiction between good performance, as measured by official statistics, and reports of “recession” in newspapers based on corporate sources. Besides large corporations, sub-sectors dependent on them such as capital market intermediaries and advertising apparently shared this feeling. In 1996, CSO had forecast economic growth to be 6.8% in 1996-97, only marginally lower than in 1995-96.[1] CSO also forecast a 10.6% growth of manufacturing, which was somewhat lower than last year, and a 3.7% growth of Agriculture (& allied sectors) which would constitute a sharp improvement. Facts available till January (when the economic survey is normally finalised) supported this forecast: Industrial production (IIP), grew by 9.8% in the first half of 1996-97, compared to an average growth of 7.5% in the eighties and 8.5% during the seventh plan. Manufacturing grew by 12.4% during April-September 1996 compared to 12.5% growth in the first half of 1995-96(IIPM). There were however some indicators signalling a significant slowing down of corporate growth during 1996-97. Among these were, (a) poor demand for credit by large corporations, (b) declining sanctions by financial institutions, (c) a fall in non-oil imports, and, (d) company first half-year sales results [qualitative results as reported in the media]. This “Duality/Dualism” in the economy between industry in general and the large corporate sector have been a puzzle during the second half of 1996-97.
Cyclical Fluctuation
Earlier economic downturns in the Indian economy have been associated primarily with cycles in rainfall and agricultural production. Over the last decade or so the connection between these agricultural cycles and Industrial production has considerable weakened. Low or negative growth of GDP from agriculture in 1995-96 had little impact on industrial production during that year. Thus such supply side [Classical/Neo-classical] cycles have not been an important feature of the economy for some time. The conventional wisdom about developing countries such as India also holds that such economies are not subject to Keynesian demand driven cycles of the kind common in developed countries. Such “Keynesian” cycles are driven by the interaction of demand fluctuations with downward price rigidity and cost-push factors (in contrast to neo-classical sectors where price flexibility ensures demand-supply equilibrium). It is my hypothesis that in the transition from a closed to an open economy such a “Keynesian” sub-sector is emerging, consisting primarily of large capital intensive corporations. A cyclical “Keynesian” slowdown or growth recession in this large corporate sector provides an explanation of the puzzle outlined above.
The last few years have seen the transition of the economy to a higher growth path following from the various policy reforms undertaken since 1991-92. These reforms also have their effect on the macro-economic interrelations in the economy. The removal of controls has to a significant extent reduced the protection provided to large corporate industry, putting competitive pressure and providing increased opportunities. This has forced corporations to rapidly achieve economies of scale by building capacity in anticipation of future growth, and to upgrade products and plants to meet potential competition. The “animal spirits” unleashed by the early spate of reforms, perhaps also resulted in over-optimistic forecasts of demand growth for new and/or upgraded products. A hump is demand for durable goods and slow adjustment in real interest rates accentuated the mismatch between capacity addition and demand growth. The deterioration in non-tradable infrastructure has raised its effective cost. This in turn has put upward pressure on costs of production. The supply problem arising from import controls on agricultural goods, which artificially creates non-tradable goods, has added to this cost pressure. Though the relative price of manufactures has fallen sharply during 1996-97, the fall was probably less in the large capital intensive sectors. This combination of falling demand and rising (infrastructure) input costs resulted in a Keynesian excess supply situation for these sub-sectors, which can plausibly be labelled a “growth recession”
Corporate Demand
Among the identifiable sources of fall in demand for the corporate sector the most important one related to the pent-up demand for higher quality consumer durable goods [e.g. cars, white goods]. The de-licensing of investment in durable goods and the de-control of imports of parts for the same, led to a boom in investment and production of consumer durable goods, culminating in the phenomenal 37% growth in 1995-96. The decline in growth of consumer durable goods to 9.8% in the first half of 1996-97(compared to 31.9% in the first half of 1995-96) and further to 6.5% in the first nine months of 1996-97 suggests that the pent-up demand for higher quality durable goods have been met. Further growth will depend on increased cost competitiveness or introduction of new (innovative/adapted) products. The former requires fuller exploitation of the comparative advantage that India has in production of (skilled & unskilled) labour intensive parts.
Other sources of decline in demand during 1996-97 included a sharp fall in the growth of World imports, a real appreciation of the Rupee and a decline in new orders for capital goods. The relatively tight money policy in 1995-6 led to an expectation that high real interest rates would persist into the future (wrongly in my view, as high interest rates were due primarily to high investment demand). This affected new demand for both consumer durable goods and capital goods in 1996. The decline in agricultural production during 1995-6 may also have contributed to the demand slow-down for the corporate sector. As a result the growth rate for April-December 1996 was 10.1% for manufacturing and 8.3% for Industry.
Import Liberalisation and Substitution
Another aspect of macroeconomic transition was the import hump commonly resulting from the opening of international trade and investment. Accelerated modernisation and development of the relatively backward consumer durable sector, likely required higher initial imports of capital goods, parts and components. This led to a higher than normal growth in imports during the last few years. This hump in imports seems therefore to have passed, accentuating the import slowdown; non-oil imports (revised DGCI&S) consequently grew by only a 2% during the first 11 months of 1996-97.
Capital Markets
The credit and capital markets are also undergoing major changes during this transition period. Growth in bank credit to the non-food sector and Sanctions by development finance institutions (DFIs) declined dramatically during 1996-97. This implies a fall in demand from large, triple, corporations. Disbursements by DFIs, however, grew at a respectable pace; implying continuing high levels of investment coupled with a sharp fall in new starts. Household saving invested in shares and debentures declined from 1.3% of GDP in 1994-5, to 0.6% of GDP in 1995-96. This decline probably continued in 1996-97, and made it difficult to raise equity funds. Besides the direct negative effect on corporate investment, this also raises debt-equity ratios, making it difficult for banks to lend for investment. These changes, along with the rise in foreign direct investment and GDR issues, suggest that the fortunes of the large corporate sector are getting linked to continuing globalisation and acceleration in foreign direct investment and inflow of equity & debt capital.
Infrastructure Cost Push
The slowing of industrial growth in the first half of 1996-97 was clearly attributable to a dramatic slowdown in the growth of the electricity and mining sectors. The 10% decline in crude oil production was a major contributing factor in the latter. During the first nine months of 1996-97 electricity production (as measured by the index) has grown by only 3.7% that is 2/3 rd of the 8.9% growth in the first nine months of 1995-96. Given the high correlation of 0.67 between manufacturing and electricity (over the past 25 years), it was somewhat surprising that manufacturing production was apparently unaffected by the slow growth in electricity production. To an extent, highly electricity intensive industries are the first to face power rationing and this would dampen the effect of less public supply on manufacturing output. It is likely that own account electricity generation has substituted for the lack of generation by electricity boards. The high growth of diesel imports coupled with normal refinery throughput is a pointer. This substitution, however, provides no relief from the rising effective cost of electricity, and the cost-push that it generates.
Investment & Capital Goods
Another aspect of the macro puzzle was acceleration in the rate of growth of capital good's production to 18.2% in the first half of 1996-97 from 14% in the first half of 1995-96. This on top of the new peak in total and Private gross fixed capital formation to 24.1% and 16.3% of GDP respectively, in 1995-96. In complete contrast, import of capital goods declined by 4% in the first half of 1996-97. This showed the strength of the domestic capital good's industry, which was initially subject to the fastest tariff reduction so as to ensure quick recovery of private fixed investment. The move to more uniform tariffs on manufactured goods has contributed to the removal of anomalies and to the growth of capital goods production.
There has, however, been a slowing down in the growth of capital goods production in the third quarter of 1996-97. As a result, the rate of growth has declined to 11.8% in the first nine month of 1996-97, significantly lower than the 17.9% growth in the corresponding period of 1995-96(Import growth till February is nil.). This happened despite an easing of monetary growth during 1996-97 and a decline in market interest (call money and T-bill rates), partly because interest rates for private borrowers lagged these developments. The growth pattern for capital goods supports the hypothesis that previously started investment plans were being completed during 1996-97, while new starts were declining. Nevertheless, fixed capital formation seems to have remained strong in 1996-97.
Macro Policy, Reforms and Growth
The above analysis leads directly to a number of Policy conclusions-- both “Dos and Don’ts”. Given the very circumscribed and limited sub-sector of the economy subject to the growth slowdown, a conventional aggregate growth stimulus would have been (and is) the worst policy response. Thus for instance a higher fiscal deficit, providing such a stimulus would have aggravated the infrastructure problem and the cost push elements and raised the inflation rate considerably. In contrast the effect on aggregate output would be limited to the effect on the large corporate sector. Thus any inflation output trade-off from such a policy would be very limited, and possibly illusory.
The appropriate policy response had (and has) several elements. The infrastructure constraint was addressed by a number of policy reforms and initiatives designed to ease the entry of the private sector in the provision of these services. The second important problem was the lag in response of interest rates to the easing monetary policy and reduced demand for credit. A number of procedural and other actions were taken culminating with more fundamental reforms in the financial sector as per the Credit policy of April 1997. The 1997-8 budget, one of the most outstanding since 1992-93, cleared the air of pessimistic expectations, which hung over the corporate sector in the third quarter of the year. The reductions in personal and corporate income tax rates will not only provide an environment for efficient growth but also will also partly address the demand growth slowdown in the corporate sector.
Sustained growth of 7% to 9% will however require quicker and bolder action with respect to the electricity sector. The most urgent is the setting up of central/regional/state regulatory authorities, which are strong and independent and have the power to discipline the SEBs and to regulate both tariffs and conditions of supply. The second critical need is for reforming the State electricity boards themselves. The faster and deeper the policy reforms in the infrastructure sector, the quicker will be our approach to a high growth (employment, output), low inflation, internationally competitive economy. Flexible and speedy policy response and a pragmatic approach to reforms are also needed to generate new leading sectors and maintain high growth.
[1] Many commentators have confused forecasts given before the year has ended with estimates produced after the year has ended. These are quite different animals, as even the best forecasters in the world frequently revise their forecasts.
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