When the GDP growth bounced back to close to 9 per cent after the slump induced by the global recession,
India's growth performance once again appeared remarkable by global comparison. But one feature that has sullied this record is evidence of a deceleration in industrial growth in recent months.
Month-on-month annul growth rates which stood at between 10 and 18 per cent during most months of the August 2009 - July 2010 period, have since decelerated and stood at less than 5 per cent in four of the five most recent months (September 2010 - Jan 2011) for which data are available (Chart 1). As a result, even though annual rates of growth are still respectable (Chart 2), some disquiet has been expressed in various circles.
It is useful to view the recent downturn as being part of longer-term trends in industrial growth. Unfortunately, since IIP (Index of Industrial Production) figures have been have been recompiled from April 2004 onwards, using the new series of wholesale price index (WPI) to deflate IIP items for which production is reported in value terms, fully comparable month-on-month rates of growth are available only from April 2005.
But an analysis of this series (Chart 2) points in two directions. The first is that the recent downturn is sharper than the one experienced during the immediately preceding cycle. Second, while the previous downturn may have begun earlier, it stretched across the period that saw the onset of the global financial crisis and recession. On the other hand, the more recent downturn has occurred in a period when the recession had bottomed out and the world economy was experiencing a recovery.
Sharper downturn
One inference that could be drawn from this is that it is not so much an export recovery as developments in the domestic market that underlie the deceleration in industrial growth.
This is of significance because, as Chart 2 illustrates, if we take a long view, after a mini-boom during the mid-1990s, industrial growth remained low for most years during the 1996-97 — 2002-03 period. After that, growth recovered and reached a peak in 2006-07. And, if we exclude 2008-09, which was a year of slow growth induced by the global recession, it appears that Indian industry had subsequently settled into a trajectory of growth of around 8-9 per cent a year. What the recent slowdown does is question the sustainability of that manufacturing growth trajectory.
The sustainability issue is all the more relevant because of the concentration of post-2004 growth in a few industrial sectors. Consider for example an analysis in which the contribution of each of 17 two-digit industry groups to aggregate manufacturing growth during April 2004 and January 2011 is computed. This is done by multiplying by the trend rate of growth of the relevant group with its weight in the index of manufacturing production.
Growth sectors
The resulting figure shows that that there are only five of these seventeen that contributed at least 5 per cent of the observed growth in manufacturing over this period. These five were all metal- or chemical-based and included: (i) manufacture of basic chemicals and chemical products (except products of petroleum and coal) (Group 30 of National Industrial Classification 1987); (ii) manufacture of rubber, plastic, petroleum and coal products (Group 31); (iii) basic metal and alloys industries (Group 33); (iv) manufacture of machinery and equipment other than transport equipment (Group 35-36); and (v) manufacture of transport equipment and parts (Group 37). These five out of 17 industry groups accounted for as much as 58.5 per cent of the total growth in the index of manufacturing production (Chart 3).
This concentration of growth in the metal- and chemical-based industries has a number of possible implications. The most obvious of these stems from the fact that the metal- and chemical-based industries tend to be among the more capital-intensive in the industrial sector. Employment per unit of investment or output in these industries is much smaller than in many other manufacturing sectors.
Hence, if growth is biased in favour of the metal- and chemical-based industries, the responsiveness of employment in the manufacturing sector to a unit increase in manufacturing output would be lower than would otherwise be the case. Growth could be jobless or inadequately job creating. This has indeed been a feature characterising registered manufacturing growth in India in recent years.
Implications
But there could be implications for the nature of growth itself. To start with, inasmuch as it is domestic demand that drives growth in these industries, that demand would in all probability be fuelled by (i) public expenditure, particularly public investment, which tends to be biased in favour of demand for these industrial products; (ii) upper income group consumption of such commodities that are normally not “necessities”; and (iii) debt-financed household investment (in housing), purchases of automobiles and consumption of “luxuries”. These are the kinds of demands for final products that tend to be directed at the metal- and chemical-based industries. Hence, growth based on such industries would depend on the availability of one or more of these sources of demand as stimuli for the industrial sector.
Besides being driven by demands of these kinds, these industries are normally in the nature of clusters, in the sense that the metal- and chemical-based industries are dependent on inputs from similar industries and serve, if at all, as inputs for downstream metal- and chemical-based industries. This results in the fact that growth or deceleration in these sectors tends to be “cumulative”. If exogenous demand trends induce a slowdown of growth in some of these industries, they have a dampening effect on the growth of related industries as well.
These two features of growth, in turn, have implications for the sustainability of the growth process. If growth is to continue, one or more of these sources of demand must remain strong. There are limits to the degree to which upper income demand can continue to sustain growth, since even though incomes are high in this group, the share of the population included is extremely small. Hence, public expenditure and debt-financed investment and consumption have to be sustained.
Lower tax-GDP ratio
A feature of fiscal reform policy has been an attempt by the government to rein in deficit spending by reining in expenditures.
This tendency has been stronger because tax policy reform in recent years has focused on the reduction of customs duties as part of trade liberalisation, on a reduction of direct taxes to incentivise private saving and investment, and of indirect taxes as part of a process aimed at rationalising them. As a net result, the tax-GDP ratio has been significantly lower than would have been the case if these changes had not been made.
A corollary is that for any given reduction of the fiscal deficit, the expenditure-reduction required tends to be higher than would have been the case earlier. Thus, the more successful is fiscal reform in terms of tax and deficit reduction, the larger would be the relative reduction in public expenditure.
From the point of view of industrial growth, therefore, the successful implementation of fiscal reform implies a transition to a deflationary fiscal environment with dampened demand.
It is possible that it is this effect that explains the slowdown in industrial growth in the period between the mid-1990s and 2003-04 (Chart 2).
But that does raise the question as to the factors underlying the subsequent recovery in industrial growth. That recovery cannot be attributed to a reversal of fiscal reform, except for the period after the onset of the downturn induced by the global recession in 2008, when the government responded with a fiscal stimulus that was adopted also because of the parliamentary elections scheduled for April-May 2009.
Debt-financed demand
Thus, during much of the period of high growth after 2003-04, the stimulus to industrial growth in all probability came from debt-financed private investment in housing, private purchases of automobiles and private consumption. Growth based on debt-financed demand, however, requires the continuous expansion of the universe of the indebted.
While enhanced availability of cheap liquidity and financial innovation that can bundle and distribute risk can encourage such expansion, at some point the threat of unsustainable defaults would slow, if not stop, the process. That would slow demand growth as well.
This is perhaps what explains the evidence of the decline of the month-on-month growth rates of the indices of manufacturing and industrial production after March 2007, which was before the global recession and well before its effects were felt in India.
Once the effects of the recession were felt, industrial growth slumped. It was the response of a government, with an eye to the impending elections, to that slump, that led to the recovery and return to high growth.
But the fiscal stimulus encouraged by the election was a once-for-all effort on the part of a government that was committed to fiscal conservatism. When it returned to power it chose to unwind the stimulus.
It is because that unwinding process was not accompanied by any neutralising surge in debt-financed private investment and consumption that we have witnessed over the last fiscal a significant deceleration in month-on-month growth rates in industrial production, which now appears to be quite steep. It s indeed too early to conclude with confidence that this is what is happening. But that seems to be an argument that explains trends in industrial growth over the medium term.
If so, we can expect that we are set for a return to a period of slower industrial growth as happened in the second half of the 1990s. Unless once again, some other stimulus, such as exports, provides the basis for growth.