R Ravimohan: Is growth headed for a screeching halt?

The slower supply response to a surge in demand has meant asset prices are now limiting progress.

India has grown rapidly in recent years. It has attracted kudos from international markets and is seen as a leading destination for investments the world over. Stock markets have welcomed these developments and the healthy corporate performance enthusiastically. The macroeconomic numbers have also never looked so good, with calm inflation, stable interest rates and healthy reserves. The world values our rupee much more now than it did for several years, again reflecting strong fundamentals. India's economic health indeed appears to be a glowing pink. Or is it turning red? Is all as good as it appears?

Undoubtedly, India's demographics and economic structures both bode extremely well for its economic growth. A population that is getting younger as the rest of the world ages is a definite advantage for getting a larger share of employment and thus will contribute to national income and growth. A diversified economic structure, not only between agricultural, manufacturing and service sectors but also between domestic and external fronts, helps in stable and widespread growth. The corporate sector has been improving its productivity and competitiveness and has been contributing to overall job creation and economic growth. A booming middle class with rising employment and income has contributed to growth by boosting broad-based demand in the country. The capacity response has been pretty robust in many sectors but very weak in others, leading to a very uneven capacity buildup.

Therein lies the fragility in our growth story. Given rapid increase in demand, and the slower response to capacity in select yet vital sectors, asset prices have now become unattractive and, in some cases, limiting. Real estate, as an example, is seriously over-priced. It is taking housing out of the reach of a large section of population and is making business, especially in the services industry, uncompetitive to be conducted from major centres in India. The crumbling city infrastructure is adding to the urban population's woes by presenting a paradox of inhuman living conditions at a world-class premium.

The strengthening rupee is another problem. Undoubtedly India needs to bump its productivity and competitiveness and looks well-placed to do that. However, it will take time and in the meanwhile, exports are hurting and will have a direct impact on employment and heightened default risk on loans to banks as exporters are usually employment-intensive and are heavily bank-rolled.

Apart from urban infrastructure, power and looming water shortages and transport bottlenecks are now seriously threatening the otherwise rapidly growing economy. The constraints are now reaching a level where investment decisions might get affected or delayed. The rural population is not faring too well either. Falling yields on crops, fragmented and disparate markets for farm products and limited non-farm employment prospects are restraining rural income. As a result, urbanisation is picking up rapidly. Income disparities are widening and investments in rural areas are falling behind. This inhibits investment in rural areas and potentially limits the much talked of Big Indian Market. Lastly, investments in softer sectors critical to supporting India's ongoing economic progress, such as education, are beginning to have their impact. Shortfall in both quantity and quality of education is now showing up as a serious shortage of manpower with the appropriate level and type of skill needed to build modern India.

This gets compounded by the presence of a large unskilled or inappropriately skilled work force, which is getting left out from the benefits of the increasing economic prospects. This could lead to uneven development, giving rise to a heightened prospect for a market-disrupting event.

Cumulatively these factors pose the triple risk of slowdown in investment, reversal or slowdown of the inflow of foreign funds and unrest over income disparity. All these are fast-moving threats, heightening the risk of a sudden break in the economic growth. Investment decisions are discretionary and lumpy. A pull-back on investment can be relatively fast and sizeable. Related to that, foreign investment which can be expected to be more short-fused can react even more rapidly. A widening income gap might cause unrest, which could manifest in a variety of ways such as labour unrest, communal disharmony, political siege and reversal in progressive reforms. The trouble with these factors is that they are low-probability but high-impact events, making it rather difficult to articulate measures that could be effective in minimising these risks without squashing the robust growth rates.

The long-term solution is, of course, to clear the policy cobwebs in the sectors that are limiting our growth as enumerated above. That will foster a more balanced and even development, spur further investment, absorb all the overseas inflows much more productively in generating assets and generate varied employment, up-skill Indian work force, make the business environment more competitive and moderate soaring asset prices. Seminal trends are strongly bullish and do support this position, subject to getting the sectoral policies right.

In the interim, transient policy solutions that could be considered to reduce the risk of a market blowout include the immediate removal of all constraints to capacity addition across sectors. For example, if various state governments announced a set of packages to boost real estate development in major cities, real estate prices will moderate, fostering huge investments, absorbing excess liquidity and reinforcing service sector competitiveness. Similarly, private enterprises should be allowed to set up vocational training facilities to train skilled manpower that is in such acute shortage. Tactical, short-term measures to moderate foreign inflows either through monetary or fiscal measures could give the export and service sector breathing time to ramp up productivity and pricing.

Market analysts also need to understand the real costs underlying the operations of Indian firms and ensure they fully account for the spiralling costs of employees and real estate and the stronger rupee in their expectations of financial analysis of firms. Metro-based, export-intensive and skill-dependent (aren't they all?) sectors are at the forefront of the risk as indicated above and micro-enquiry into specific investments needs to be re-evaluated. These firms themselves need to ensure they are taking all measures to hedge against these risks and hasten their productivity enhancement measures to grow out of the problem. De-leveraging risk on balance sheets, thus shortening cycle times for monetising businesses would also help reduce value at risk.

The author is the Managing Director and Regional head for South Asia for Standard & Poor's. The views expressed here are his own. He can be reached at r_ravimohan@standardandpoors.com