Ahead, the road’s getting rougher for the Juggernaut

“Slowdown” screams the headline; “IIP plunges to 5.4%” follows. The witchdoctors and shamans are out in strength. A daily newspaper leads with the headline “Interest rates are hurting, the slowdown has begun”.  It is a curious thing that rectitude in monetary policy has become such a wildly popular scapegoat. But that is perhaps precisely the point. A thought culture that requires a scapegoat is just one step removed from primitivism – it looks to the magical charm that will make all troubles go away. And that magical charm is lower interest rates.

Public economic policy in the post-Great Depression period was seen as a tool of demand management. Supply was seen to be autonomous, driven by the dynamics of the market. If demand growth was weak, public policy – fiscal and later monetary – would give it a boost. How did you determine whether demand growth was weak or not? If employment was falling, demand needed a shot in the arm; approximate that to output falling and then fine-tune that to output growth being below a “potential” threshold. When such economic morbidity came to pass, prices turned soft, because demand was lower than supply; that is, inflation was negative or low or fine-tune to lower than some “threshold” that corresponded to the “potential” growth rate. Thus the prognosis and prescription emerged – with inflation as the thermometer for economic health. If inflation was falling and was lower than the threshold you ease monetary policy and vice versa.

The problem, as you may have noticed, is that the analytical scheme assumes that supply will take care of itself. Modern economics practice recognises the supply problem insofar as “structural” factors are concerned, and operates on the idea that demand (consumption) and supply (investment) cycles are generally out-of-phase and monetary policy can help play a bridging role.

However, there are other serious problems that underpin supply.

First is the relative autonomy that many commodity markets seemingly have in determining prices. Ask yourself this question. Everybody and his aunt, is talking about a recession in the USA drawing in Japan and Europe and perhaps China – a global slowing: Which means weak global demand prospects. But crude oil prices are testing new highs – even adjusted for the fall in the dollar – and so are wheat and rice and edible oil and iron ore. Why? Either the markets have gone nuts, which is unlikely. Or more plausibly there is a complex interplay of how the principal protagonists, including central banks, behave, each agent’s choice affecting the reaction of the other. Given that in this process various asset markets play an important role, and developed market financial markets in serious disarray, the whole business becomes very murky.

Second, in India, i.e. Bharat, the heavy hand of sarkar always does the expected – it slows things down. We know that many new cement plants have been delayed because clearances and coal linkages have not come in time. We also know that there is a huge shortfall in power generating capacity installation because of project delays. We know that highway rollout is behind time because of problems in obtaining clearances and acquiring land. The list can go on.

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Now, to the Index of Industrial Production (IIP) – the proximate cause for this story. In January 2008, the IIP increased by 5.4%, down from 7.6% in December 2007 and an average of 9.0% for the first nine months of 2007/08. There are three key red flags in the January 2008 IIP data release. The first is the overall low growth number, second is the negative growth rate in consumer durables; third is the sharp decline in the growth of capital goods output to 2.1% from strong double digit growth rates for 58 of the previous 67 months and the lowest level since June 2002.

The overall lower growth rate is partly high-base effect – because output levels and growth during December 2006 and March 2007 – had been unusually strong. The second factor is the weakness in the two-wheeler market which is a consequence of first, the high penetration rate – 8 million units per year is a large number even for a population of 1.1 billion; second, the reluctance of lenders to finance two-wheeler purchase, not because of monetary policy, but the poor performance of many of these loans. So two-wheeler output was down by 3.6% in January 2008 and also down by 5.6% for the period April-Jan 2007/08.

However, production and sales of cars and SUVs have however been growing. In January 2008 output of cars/SUVs was up by 7.5% and by 14.0% for the period April-Jan 2007/08. In the construction of the IIP, cars/SUVs have a weight of 4.94, while 2/3-wheelers, bicycles and their tyres & tubes have a combined weight of 15.83 (all out of a total of 1,000). That is, cars/SUVs have a weight that is less than one-third that of 2/3 wheeled vehicles, including bicycles. The value of cars and SUVs is however more than three times that of 2/3 wheelers – the opposite of the IIP weights. The IIP was based on the India of 1993/94. There is an urgent need to update that, else signals can be confusing.

Finally to capital goods: The drop in capital goods output growth to 2.1% was driven by the decline by 3.8% in the machinery sector – down from 10% plus growth in December 2007 and for many, many months preceding that. Is investment tanking? How should one understand this decline? As a demand induced consequence? The anecdotal evidence suggests that machinery manufacturers have full order books and if demand had become a problem, output could hardly have plummeted from 10% to –4% in one short month. The same argument militates against capacity constraint being the operative factor. May be it was a statistical blip.

Some numbers for February 2008 are available. Power generation was up 9.6%, commercial vehicle output up 9.9% and cars/SUVs were up 18.6%. Two-wheelers were still down by 10.2% and if the Tata Nano takes off next year, more blood will perhaps run.

The Indian economy is clearly not racing at the speed it was in the last two years, but it has not slowed down to an amble either. There is plenty the government can and must do – push infrastructure and take pre-emptive steps in a world where wheat and rice have crossed $500 per tonne, with perhaps more bad news to come. Inflation has taken centre stage. Nobody asks a person in the thin air at 20,000 feet to run flat out as if he would at sea level. Any suggestion to boost demand now, is akin to doing precisely that.

(The author is Economic Advisor, ICRA)

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Published in Mail Today, Thursday, 14 Mar. 2008