In an announcement that shocked both the government and the markets, the CSO declared recently that the month-on-month annual growth rate of industrial production had turned negative in October 2011. The government quickly played down the evidence, seeking to talk up the markets. In this it was aided by the fact that the decline was driven to some extent by an unusual 25.5 per cent annualised decline in production in the capital goods sector. The Chairman of the Prime Minister’s Economic Advisory Council argued that the fall in capital goods output was possibly due to statistical underreporting. The message was that the numbers are likely to be corrected when the figures are revised, and therefore should give no cause for alarm.
But as the accompanying Chart displaying month-on-month annualised growth rates suggests, medium term developments are such that there still is cause for concern. To start with, the decline in month-on-month growth rates is a trend rather than a one-time phenomenon, though October is the first occasion in recent times when the figure turned negative. The ‘V-shaped’ recovery from the 2009 recession seems to have peaked and reversed itself as far back as February 2010. That was disappointing enough because the recovery had established India as one among the countries that had quickly put the effects of the global crisis behind it. To boot, since then industrial growth has slipped, stabilised for a while, and then registered the recent sharp downturn.
Secondly, while suspicions have been expressed about the veracity of the figures because of the surprisingly large 25.5 decline in the production of the capital goods sector, the October figures point to a negative rate of growth in all industrial groups in the “use-based” classification. Even consumer goods, with a weightage in the index of industrial production that is more than three times as much as for capital goods, registered a decline, even if of a much smaller 0.83 per cent. The trend, if not the magnitude, is general.
A third feature coming out of these growth figures is that, if the October figures prove to be statistically acceptable, the month-on-month growth rate is at a trough that is close to its worst performance during the 2009 crisis. If the 2009 recession was a downturn worth taking note of, so is this.
With figures as striking as these, it is difficult for both government and industry to dispute the decline, even if doubt is expressed about the magnitude of the fall. So what has followed is an attempt to dilute the significance of the downturn by attributing it largely to the effects of the Reserve Bank of India’s attempt to raise interest rates to combat inflation. In fact the RBI has even been criticised on the grounds that its response to the inflation was overdone, and yielded less in terms of inflation control than growth deceleration.
There are many advantages to this position. First, it makes the downturn and possible recession an engineered rather than a systemic phenomenon. This provides the argument for those who would not like a proactive response to the recession on the part of the government. Second, it strips the whole gamut of other policies of the government, including those referred to as the “economic reform”, of any role in precipitating either the inflation or the industrial volatility that underlie the current downturn. Third, it ignores the role played by the high growth in services, or outside the productive sectors, in creating the basis for inflation in recent years. More income and less commodity production normally implies high inflation, more imports or both. Accepting that link would amount to accepting that within the current trajectory high growth would lead to high inflation. And, fourth, since inflation divested of its relationship with growth is expected to moderate in due course, the RBI is expected to respond in reverse by reducing interest rates and easing monetary policy. This makes the recovery from the downturn seem inevitable.
There are two important relationships that arguments of this kind ignore. The first is that the inflation, the response to which is supposed to have triggered the downturn, is not an accidental occurrence. There are strong direct and indirect cost-push effects that the recent economic policies of the government have had that are substantially responsible for the inflation. To that extent, policies other than the responsive hike in interest have had an important role to play, even if the role of the latter in driving the downturn is accepted.
Second, the effects of the interest rate must work through some mechanism. Normally, it works through a dampening of demand, which reduces the degree to which the system is overheated. That is, the mechanism is one that seeks to alter the supply-demand balance by squeezing demand, in order to reduce prices. Its success is, therefore, predicated on a decline in demand and growth. Relying on the interest rate implies accepting the link between growth and inflation.
Conventionally, the perception has been that the effects of the interest rate on demand works through its dampening effect on investment. This reduces investment demand in the first instance, and by limiting the income generated through new investment curtails growth in consumption demand as well. The efficacy of the measure depends, therefore, on the responsiveness of investment to interest rate increases. This has in the past been ambiguous, and is more so now given the option of borrowing from abroad for the big corporates.
This questions the argument that interest changes have generated the recent sharp downturn. However, in more recent times, credit has financed not only productive investment by firms and farms, but a substantial volume of housing investment and consumption by households. Interest rate increases discourage such investment and consumption more than they adversely affect productive investment, making the effects of such hikes on demand much more potent.
It is for this reason that interest rate increases are likely to have had strong adverse effects on growth. The question remains as to why they have been less effective in combating inflation. If cost-push factors play an important role in explaining inflation, the dampening effects of rate increases on the price rise are bound to be lagged and limited. That seems to be the case in India today.