News that the month-on-month rate of growth of Indian industry as measured by the Index of Industrial Production (IIP) was a negative 1.8 per cent must trouble the government. This is the fourth time in nine months that the rate recorded was negative. There has been only one month over the year ending June in which the rate has exceeded 5 per cent. That compares with rates of 20 per cent attained just before the global crisis of 2008 and 15 per cent at the height of the post-crisis recovery. Clearly, organised industry, which the IIP covers, is in the midst of a slump.

To speculate on the factors explaining the slump we need to revisit those that drove the pre-crisis boom. Three in particular have received much attention. One is export demand, with some evidence that it contributed to buoyancy in some non-traditional export sectors like chemicals, pharmaceuticals and even engineering. However, manufactured exports have never been the prime driver of industrial growth in the Indian context, and they have been adversely affected by the European crisis only recently. Other factors must have had a greater role to play in triggering the industrial slowdown.

A second source of stimulus for industrial growth has been public expenditure, which in recent years has been financed substantially with debt. The neoliberal obsession with the size of the public debt to GDP ratio and well-above-target fiscal deficit to GDP ratio has indeed put pressure on the government to rein in expenditure. This, together with a biased revenue sharing arrangement favouring the Centre, has constrained expenditure by the state governments to an even greater extent. And though the central deficit has widened in recent times, the low level of the tax to GDP ratio implies that the level of spending or the fiscal stimulus associated with that deficit would not have large. Thus, repressed government expenditure would indeed have limited the rate of industrial growth. However, this is a longer-term tendency and has been operative for some years now. While a sudden slowdown of growth may have aggravated this problem by adversely affecting revenue generation, fiscal conservatism cannot be the original cause of for such a slowdown.

Which brings us to the third of the factors that contributed to the pre-crisis boom: debt financed private expenditure. Prior to the crisis, easy availability of credit at relatively low rates of interest encouraged housing investments and debt financed consumption by households. Such spending triggered a manufacturing boom. This stimulus seems to have been adequate not merely to neutralise the effects of the longer-term deceleration in demand resulting from fiscal conservatism, but also to drive and sustain the boom. In all likelihood, it is the tapering off of this source of demand that could explain a substantial part of the recent deceleration in industrial growth.

Many developments could have contributed to the dampening of this source of demand. First, the evidence that bank exposure to retail credit has increased hugely at a time when the bank credit to GDP ratio has risen substantially. This has been putting pressure on at least some of the major banks to hold back on retail credit expansion. Second, the rise in the interest rate as a result of the Reserve Bank of India’s decision to hike the reference rates in response to inflation. Costlier credit would have discouraged new borrowers and forced those already exposed to hold back from further borrowing because of the increased debt service commitments on existing debt. Finally, the RBI seems to have veered towards limiting liquidity in the system, as part of its anti-inflationary thrust, reducing access to credit for at least some borrowers who had been earlier considered eligible.

If this is indeed the set of factors underlying the industrial slowdown in recent months, the prognosis is by no means good. Inflation has not yet been controlled and is likely to accelerate for a number of reasons: the bad monsoon that would push up domestic agricultural prices; the drought in countries like the US that is expected to push up global food prices, with knock-on effects in the domestic economy; and, the desperate desire on the part of the government to increase the administered prices of food, fuel, fertiliser and other commodities, as a way of reducing the deficit on its budget.

If inflation rises for these reasons, the RBI would not be willing to reduce interest rates from their high levels, with implications for debt-financed spending of households. Moreover, the government would be under pressure to reduce spending as a second way of reining in inflation, weakening in the process another stimulus for industrial growth.

The slowdown itself, by affecting the confidence of both the banks and households, would reduce the willingness of the former to lend and the latter to borrow. This would squeeze private demand further. And there are no signs whatever that exports could come to the rescue of a flagging industrial sector, given the global downturn. In sum, the news is by no means good. Unless the government can get its act together, expand demand and cap inflation, rather than hope that another dose of reform would help revive growth, a recession is imminent.