:: Jayati Ghosh

India Inc must recognise economic realities

By Jayati Ghosh

May 19 : The election results have clearly come as a shot in the arm for the stock market, as well as business expectations, both of which had only recently plumbed the depths as the economy was battered by the global crisis. But the celebratory mode of India Inc, which has been delighting that the Left defeat now gives a "free hand" to more liberalising reforms, needs to be moderated with recognition of the economic realities, which continue to be less than positive.

In March 2009 India’s exports declined by 33.3 per cent compared to the previous year, making it the largest decline and the fifth consecutive month of falling exports. This sharp downturn in exports has affected output growth in a range of traditional and modern manufacturing sectors. This in turn is reflected in industrial growth, with the index of industrial production showing a sharp deceleration and subsequent contraction of output in the organised industrial sector. But this can be only partly explained by the decline in goods exports, and so it is likely 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, despite the half-hearted fiscal stimulus in the wake of the global crisis, that was in addition to 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. It is to be expected that the dominantly middle and upper-middle class beneficiaries of the Pay Commission’s recommendations would direct their windfall gains and higher salaries to increases demand for manufactures and luxury services. If industrial growth has been indifferent or poor in spite of that, then other factors must have neutralised the positive 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 elections during April and May would have substantially increased spending in various forms. Not only would government expenditures been higher on average as incumbent governments seek to push ahead with programmes and concessions to win over the electorate, but 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. But even this 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 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 manufacturing exports, services exports are also being hit by the downturn.

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.

The other important mechanism is the reversal of portfolio capital flows to the country, which had been massive during its recent period of high growth. The effects of that reversal (amounting to a net outflow of $14 billion over 2008-09) were the collapse of the stock market boom and the 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 increase 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.

This experience has a larger lesson about the effects of liberalisation on manufacturing growth in India. It was expected that trade and industrial policy liberalisation in India would result in a restructuring of manufacturing production that would increase Indian firms’ presence in global markets. On the other hand, the liberalisation of the rules and terms for entry of foreign firms was 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.