As the world braces itself for another recession, India needs to ponder whether it too faces the prospect of another industrial slowdown. Since the dynamism that characterised services in recent years spread to industry only after 2003-04, this could imply a shift away from the high-growth trajectory the government celebrates.
One reason to suspect that this may already be occurring is the trend in the lead indicator, the Index of Industrial Production. That index suggests that the year-on-year growth of manufacturing production during the April-August 2011-12 period had slowed to a substantially lower 6.0 per cent, when compared to the 9.2 per cent recorded during the corresponding period of the previous year. What is even more disturbing is that the index of manufacturing production, despite fluctuations, has remained close to its July 2010 level for more than a year.
It is in this background that we need to look at evidence on the financial performance of the private corporate business sector released by the Reserve Bank of India. While covering a varying number of companies (each year) from the large industrial sector, this dataset is known to cover a substantial proportion of that segment in terms of paid-up capital. It, therefore, provides an indication of how the corporate sector has been performing over the years since 2004-05, which is when India is seen as having transited to a higher GDP growth strategy of 8 per cent plus. That shift was partly due the spread of growth that was concentrated in services to industrial production in general and manufacturing in particular. So if industry is losing momentum and profitability, that trajectory itself may prove transient.
What the evidence (presented in the accompanying Chart) shows is that from the point of view of corporate profitability, there have been two identifiably different periods since 2004-05. The years of celebration began in 2004-05 and stretched to 2007-08. During these years the profit margins on sales rose significantly, from 8.3 to 11.8 per cent. This ensured high year-on-year rates of growth of profits when sales growth was above some threshold (as in 2006-07), and reasonable rates of profit growth in years when sales growth was normal. However, in a year like 2007-08, when average profit margins peaked, the growth in aggregate profits was held back because of higher outflows on account of interest payments. The threshold for growth in sales required for high profit growth was considerably raised when the interest burden carried by the corporate sector was high.
The second period began in 2008-09 and is still continuing. Because of the global recession, 2008-09 was a bad year. As a result of the impact of the recession, profit margins fell, sales growth dipped and, for a combination of reasons varying from a liquidity crunch to higher inventory accumulation, the interest burden carried by the corporate sector rose significantly. The result was a collapse of the rate of growth of profits into negative territory. Industry experienced a profit-squeeze of sorts. While things have improved since that year, partly through a rise in profit margins aided by state subsidies and tax concessions, till 2010-11, nominal profit growth had not returned to the levels of the pre-crisis period despite high inflation.
It is in this background that we must assess prospects for the near future. The adverse effects on demand of domestic inflation that has ruled high for many months now are likely to be increasingly felt as households adjust their budgets. With that inflation substantially impacting food articles, a larger share of domestic income would be diverted to food consumption and other priorities such as fuel and transportation. As a result the balance available for consumption of manufactures is likely to be squeezed, with attendant implications for demand.
What could be even more damaging is a sharp fall in credit-financed consumption and housing investment by households. This could result from the sheer inadequacy of credit. With evidence of a growing proportion of defaults in the retail loan portfolio of banks, they have been forced to turn cautious. Thus credit flow is being affected adversely from the supply side for housing and for purchases of goods such as automobiles and durables. But credit offtake is being affected adversely on the demand side as well. It is not jus that real income erosion is pushing some potential borrowers out of the market. The sharp rise in the equated monthly instalments on loans as a result of the anti-inflationary interest rate hikes introduced by the Reserve Bank of India, has made credit-financed consumption “unaffordable”. In sum, domestic demand and sales are set for a significant slowdown. To add, with more certainty that the global economy would experience a “second dip”, exports are bound to lose the buoyancy they have shown in recent months.
Thus, the rate of growth of sales is bound to fall below threshold in the coming months. To add, profit margins are likely to be further squeezed because slowing demand and rising inventories are unleashing competitive price reductions at a time when costs are higher. Finally, with interest rates having risen hugely, those firms that are unable to source finance from global markets would experience a sharp increase in their interest burden. The net result would be a sharp decline in profit growth, with a return to growth rates in negative territory.
All this occurs at a time when the government’s ability to intervene to support profit margins, as it did in 2008-09, has been eroded by its own policy stance. Unwilling to tax surpluses and adequately penalise tax evaders, and caught in its obsession with reining in fiscal deficits, expenditure increases at the margin have come to rely on windfall gains such as sale of spectrum or big-ticket divestment of public sector equity. Politically and economically the government is not in a position to resort to such measures. Thus one factor that has supported profits, domestic and foreign, on India soil is on partial hold. This promises to adversely affect manufacturing profitability and depress profit growth.
With demand and profits under pressure, industry’s contribution to India’s growth story is likely to be significantly smaller. And, with the global economy in turmoil, services, especially those dependent on exports, are bound to be less buoyant. It is difficult to understand, therefore, the economics (as opposed to the arithmetic) underlying the Planning Commission’s optimism about moving the economy to an even higher 9 or 9 per cent plus rate of growth over the XIIth Plan.