... but for how long?

Even as a collective sigh of relief is heaved about the 14.4 per cent growth in industrial production during November, which takes it to above 10 per cent for the year so far, there are some elements on the horizon that presage a slowdown in the current momentum. Business Standard carried a report last week about the slowing growth in the housing loan market. This segment, which grew by over 50 per cent during 2005-06 (according to the Reserve Bank of India's estimates), is currently ticking over at a significantly lower 25 per cent in some key markets. Higher interest rates are one contributor to slowing demand. On the back of sustained increases in its benchmark rates by the Reserve Bank of India (RBI), the last one month's two-stage increase in the cash reserve ratio (CRR) induced lenders to hike their rates across the board. However, the other contributor to slowing demand is the sharp increase in property prices across the country.

In the mature economies, housing activity is seen as an important leading indicator of the business cycle, because of its multiple linkages with the rest of the economy. Construction provides its linkages, of course, to sectors like steel, cement and paints, but in the Indian context, also to rising employment amongst the unskilled segment of the workforce, of which there are so many. All told, it is clear that the boom in housing construction, which in turn was a consequence of the sharp fall in interest rates in the early part of this decade, has been a significant contributor to economic growth in India over the past few years. The question is: does the recent slowdown in lending activity in this sector presage a more widespread slowing of the economy?

In a sense, that is what the RBI has been aiming for with its attempts to curb liquidity, through interest rate and CRR hikes. Of the more interest-sensitive sources of demand, housing is the most responsive to the RBI's policy signals. From this perspective, the slowdown may not be an undesirable outcome. Industrial investment activity shows no signs of abating in response to the monetary policy stance. The adjustment must, therefore, come from individual spending decisions, including those relating to buying homes. Given the extensive linkages that construction has, however, it is difficult to predict whether this moderation will remain within acceptable bounds. This is a scenario that the RBI must prepare to deal with when the time comes.

Speaking of tight liquidity conditions, the RBI has been given more leeway for manoeuvre by the Union Cabinet's approval of the abolition of the 25 per cent floor on the statutory liquidity ratio (SLR, which reflects the amount of bank deposits that must be kept in the form of government-approved securities). Once the Ordinance is issued, the central bank will be free to set the requirement at a level consistent with its assessment of the macroeconomic scenario. Given that the RBI has been tightening rather than loosening the monetary purse-strings, there may be no immediate response, especially since the inflation rate is above the 5.5 per cent upper limit preferred by the RBI. But with bank lending continuing to grow faster than bank deposits, the banking system as a whole is now quite close to the SLR floor. Whenever the RBI believes that it has achieved sufficient cooling of the system, it now has the leeway to open the tap on bank lending so as to prevent a sharp increase in interest rates.