Subir Gokarn: 2005-06: A classic battle

There is significant momentum being generated by buoyant demand.

Financial year 2005-06, beginning this Friday, will keep Indian economy-watchers on their toes. The dominant opinion amongst forecasters, both inside and outside the country, is that the current momentum will persist.

There is, as usual, a range of opinion on the growth rate, but nobody seems to be particularly worried about a genuine slowdown. At worst, the growth rate may slow a little bit because of a relatively high base, but not much weight is being put on this eventuality.

While there may be good reason for this optimism, we cannot afford to ignore a variety of risk factors that have come into play over the last few months and could cause some turbulence.

There are risks visible on both the demand and supply sides. On the demand side, the most significant concern is the likelihood of the economy overheating, i.e. inflation rates climbing as capacities in the economy are stretched as a result of three successive years of growth of 7 per cent or more.

I explored this issue in my column of February 14. Comparing the previous instance of three years of rapid growth with this one, I came to the conclusion that the economy was in a distinctly different situation this time around.

The inflationary tendencies that manifested then are simply not visible now and the same rates of growth in non-agricultural GDP are being achieved with far lower rates of inflation.

This is despite crude prices reaching within 15 per cent of their all-time highs (in real terms). Clearly, productivity gains, induced by internal and external competition, among other things, are allowing Indian producers across the board to make better and better use of their resources.

This provides some assurance that rapid growth can be sustained for at least some more time without forcing the policymakers' hands into an anti-inflationary stance.

However, within the pattern of growth that the economy has experienced over the last two and a half years lie the seeds of a potential slowdown. For the first half of the period under consideration, the industrial recovery was driven by the metals and automobiles sectors.

The former benefited from a combination of external demand, mainly from China, and domestic buoyancy in construction, automobiles, and the like. The latter rode the significant decline in costs of financing, induced by falling interest rates and intense competition in the retail finance business. Just as these two factors were apparently running out of steam, investment activity began to pick up.

In the second half of the period, machinery and equipment took on the lead role in the recovery. For about eighteen months now, it has been the fastest-growing industrial sector.

While an investment-led recovery is always desirable, because it boosts demand in the short term while adding capacity for future growth, experience suggests that it is prone to cycles. Sooner or later, producers decide that enough is enough and more capacity will not be viable.

At this point, the cycle turns and what was until then a leading sector turns into a significant drag on the economy. Commercial vehicles are a case in point. Sales have been going great guns for the last couple of years, but this means that virtually anybody who wanted to buy a new truck or replace an old one has done so already. Our own forecasts suggest a significant slowdown in the year ahead, a view that appears to be shared by at least one leading manufacturer.

What may be true for commercial vehicles need not necessarily be so for capital goods in general. But, it is difficult to deny that if an investment upturn has lasted two full years (a landmark, which will be reached this September) the likelihood of a turning point increases with every additional month. Of course, this does not mean that nothing can be done to postpone it.

Some years ago, the issue that dominated the policy debate was whether the government could use "pump priming"""increasing its own capital spending""to kick-start an industrial recovery. In essence, the highways programme did exactly that.

Of course, it cannot be expected to continue to provide momentum unless the quantum of spending increases each year. After reaching a plateau during the last couple of years, this year's budgetary allocations suggest a significant increase. With the pump already being primed, in this version, it should play the part of an "automatic stabiliser".

On the supply side, the most critical risk is obviously the behaviour of oil prices. After a spectacular increase last year, they appeared to be moderating. In recent weeks, however, they have again displayed the kind of exuberance that can only cause deep damage to oil-importing countries.

While the global growth consequences of the run-up during 2004 did not appear to be severe, the potential impact of high oil prices should not be minimised. India is particularly vulnerable on a variety of fronts.

The share of transportation fuels in the average household budget appears to be rising, what with all those millions of two-wheelers and cars being bought. Transport services have been a powerhouse as far as GDP growth is concerned and these can only be adversely affected by rising fuel prices.

From the fiscal perspective, the government has to make a very difficult choice between increasing the retail prices of kerosene and LPG or paying out higher subsidies on them. A similar, tough decision will have to be made for fertilisers.

Oil prices will have their impact across the globe and, therefore, will not appreciably affect our relative competitiveness. However, our domestic infrastructure is unique to us and can cause it to deteriorate. Since the passage of the Electricity Act in 2003, we have had endless talk of review and streamlining, but very little action.

It is inconceivable that the economy can continue to grow at the pace it has been doing over the last couple of years without ramming head-on into the power constraint sooner rather than later. The Act does provide some short-term relief by facilitating trade in what until now had been purely captive capacity. But, this potential still needs sensible action by state governments to be realised.

In sum, the year 2005-06 is going to be one in which the "irresistible force meets the immovable object". There is, without question, significant momentum being generated by buoyant demand, which is being helped along by productivity gains. But, crude prices and the painfully slow progress on domestic infrastructure threaten derailment. It is a classic battle in the making.

The author is chief economist, Crisil. The views here are personal.