India - Triple Punch for Economy

The world economy enjoyed an exceptionally strong (and wholly unexpected) boom in the period 2002-2007 with global growth averaging about 5 percent a year. It was no coincidence that India’s record five-year growth at nearly 9 percent a year occurred in 2003/4-2007/8. If anyone needed further proof of the wisdom of India’s “opening up to the world” policies of the 1990s and beyond, it would be hard to find a stronger vindication. While domestic factors (such as surging savings/investment, a services boom and the cumulative effects of earlier reforms) probably played the dominant role in driving India’s growth acceleration, the benign international environment of strong trade expansion and burgeoning cross-border flows of capital and technology undoubtedly played a significant part. But globalization cannot be a bed of roses. There are bound to be some thorns. When the world economy runs into rough weather, participant countries can expect some pain. In 2008, the combination of the global credit crunch and the steep rise in international commodity prices (especially oil) has dealt India a triple punch: through plummeting stock prices, an unprecedented spurt in inflation and slower growth.
The blow to equity prices came first, beginning January 2008. A potent brew of souring global equity markets and a reassessment (by investors) of the oil-import-dependent Indian economy sent the Sensex tumbling down 40 percent from the inflated levels of mid-January. The second big punch landed in March 2008, as soaring prices of oil, food (especially edible oils) and metals transformed a “comfortable” inflation rate of around 5 percent to an extremely painful 12 percent rate in four short months. This has been the sharpest rise in headline inflation experienced by the country since Independence. It may also have been the least anticipated. Basically, the global economy has delivered a terms-of-trade shock to which the Indian economy and policies have to adjust. Some of the price shock may correct over time as the global commodity price boom subsides. But it is unlikely that international oil prices will revert below $80/bbl or that fertilizer prices will return to pre-2008 levels. The enduring part of the price shock poses significant challenges to fiscal, monetary, price and exchange rate policies as part of the necessary adjustment to permanently elevated relative prices of key commodities. It also implies an inevitable, though hopefully temporary, decline in the country’s growth rate.
The third punch, to economic growth, has not yet been fully delivered. Yes, the commodity price shock has already begun to take its toll of growth momentum. But that’s only part of the blow to growth. In fact, the price surge was a byproduct of the strong global boom. What has yet to hit India is the full weight of the post-boom slowdown in the global economy. This point may not be adequately appreciated in India for three reasons. First, there is a belief that the “sub-prime” related global credit crunch is now past its worst point and financial market recovery is under way. Second, despite the global deceleration, India’s exports grew at a healthy 22 percent (in dollars) in April-June 2008. So where’s the worry? Third, surely the penalty in the form of slower growth is already accounted for in the various downward-revised growth projections for the Indian economy in 2008/9? For example, the RBI has trimmed its projection to 8 percent; CRISIL has reduced its forecast down to 7.8 percent (from an earlier 8.5 percent); NCAER has dropped it to 7.8 percent (from its earlier 8.5-8.8 percent range) and JP Morgan to 7.0 percent (from 7.5 percent). Some of these projections look quite optimistic now that data for industrial production shows growth of only 5.2 percent in the April-June quarter of 2008, compared to 10.3 percent in the previous year. Besides, it’s 2009/10 that I would worry about more, for reasons outlined below.
To elaborate on the first point, every passing quarter suggests that the severity of the financial market problems (that emerged a year ago) and their adverse impact on national output in the US and Europe is likely to be greater than originally expected. As former US Treasury Secretary, Lawrence Summers puts it (Financial Times, August 7, 2008) : “There is growing consensus that the west is facing the most serious financial crisis since the second world war…Four vicious cycles are simultaneously under way: falling asset prices are forcing levered holders to sell, driving prices further down; losses at financial institutions are reducing their ability to finance investment, which in turn reduces asset values, causing further losses; the weakness of the financial system is reducing growth, which in turn weakens the financial system; and falling output is hitting employment, which in turn reduces demand for output.” Summers estimates that “the American economy is operating between 2 and 2.5 percent below its sustainable potential level.” Worse, he expects further slowing of US growth could lead to a near doubling of this gap in the next year or so. Recent reports indicate that growth in Europe and Japan is also slowing more than earlier expected. Asia’s trade-dependent economies will undoubtedly suffer from this slowdown in US-Europe-Japan. India’s growth cannot be immune to these developments, no matter what the recent export data show (which are any way inflated by petroleum exports from a couple of private refineries).
So, the world economy’s punch to Indian growth has not yet landed with full force. It will have done so by 2009. Add to that the other growth-retarding factors that are in play already, including: the higher interest rates from tightened monetary policy (perhaps the July measures were excessive?) and much higher government borrowing because of huge subsidies on oil, fertilizer and food; the likely decline in savings and investment in 2008/9 (see my piece in BS June 26, 2008); the negative effects of four years of “pause” in economic reforms; the downturn in the business cycle in industry; and the over-reliance on monetary policy to cope with the recent terms of trade shock. All things considered, it should not be a surprise if India’s economic growth dips below 7 percent in 2009/10. Of course, much will depend on the uncertain trajectory of international oil prices.
The author is Honorary Professor at ICRIER and former Chief Economic Adviser to the Government of India. Views expressed are personal