Subir Gokarn: Slowdown around the corner?

Amidst the general euphoria about the state of the economy, reflected in both the GDP growth numbers and stock market indices, it may sound a little churlish to be talking about a slowdown. However, looking a little beyond this year, into 2006-07, the possibility that growth will not continue at the current rate has to be considered. A number of indicators point to this scenario.

The first is the early evidence on a slowdown in the growth of corporate profitability. Second-quarter numbers, by and large, suggest that the impact of higher input prices, both energy and raw materials, is being felt. Rising costs appear to be deterring growth; aggregate sales growth also slowed appreciably during the quarter. With low import barriers for most manufactured goods, producers have great difficulty in raising their prices. Inevitably, profits suffer.

For about a three-year period, which ended in 2003-04, the corporate bottom line received a significant boost from falling interest rates. Rates bottomed out during 2004-05 and have been slowly rising during this year, so they are no longer contributing to growth in profits; in fact, they are partly responsible for the slowdown. Over the last several months, companies have probably been able to offset some of the cost pressure, by virtue of both continuing productivity growth and declining prices of certain services, such as air travel.

Productivity may well continue to increase, but input prices will bottom out sooner rather than later. Taken together, these tendencies clearly suggest that, in the absence of any positive developments on input prices, growth in profits will continue to slow down. The second-quarter numbers are more likely to be the beginning of a trend than an aberration. Further, considering that slowing sales growth is contributing to this, we should keep in mind that aggregate corporate sales numbers are quite closely correlated to broader indices of economic performance.

This analysis raises a number of issues. One relates to the impact of a sustained slowdown in earnings growth on stock prices. Whatever one's beliefs about whether the market is overvalued or not today, the slowdown in earnings will act as a dampener. If prices stabilise at current levels, opportunities for capital gains will soon fade away, along with all the good things that come with it""high "wealth effect" spending and tax revenues on capital gains, for example. A sluggish market will also slow down the inflow of foreign investment, which will set in motion another set of factors, which are explored later in the article.

A second factor concerns the effect that slowing profit growth will have on investment spending. This has been an important driver of industrial growth over the last couple of years, but, significantly, it appears to have been largely confined to existing companies. Of course, large investment plans are driven by horizons that lie beyond the business cycle. Companies that are already implementing capacity expansion are unlikely to slow their projects down. However, as profit growth slows, the freedom of managements to commit more resources to new capacity becomes constrained. The flow of funds into new projects is bound to be adversely affected. Another growth driver will downshift gears.

A third set of factors to consider is the interest rate scenario and the impact that the Reserve Bank of India's (RBI's) rate hike will have on overall economic performance. The 25 basis point increase in the reverse repo rate in October 2005 was the third since October 2004. Obviously, the first two hikes, in October 2004 and April 2005, do not appear to have appreciably affected the growth momentum. The RBI was pretty confident that the most recent one would not have any immediate impact, projecting GDP growth for 2005-06 in the 7-7.5 per cent range. However, its expectations for growth in 2006-07 are not yet public. It would be interesting to know what they are, because there are reasons to believe that higher interest rates may have a little more bite this time around.

Even without the RBI's intervention, interest rates have been noticeably hardening over the last few months. Both increasing demand and a tightening supply of liquidity are responsible. Demand for credit has grown proportionately with a buoyant industrial sector. Supply has been constrained by the rather dramatic change in the balance of payments scenario. After being in surplus territory for quite some time, the current account came up with a large deficit in the first quarter of this year, about 3 per cent of GDP. Higher import bills, for oil as well as other requirements, were the obvious reason.

This is not such a bad thing in and of itself. However, it does make a tangible difference to the liquidity situation. For quite some time, the RBI's absorption of reserves provided it an enormous cushion with which to manage liquidity and support the benign interest rate environment. Now those large foreign investment inflows are being used up to finance the current account deficit. Because investment flows continue unabated, there has been no problem on the balance of payments front, but domestic liquidity has tightened, exerting upward pressure on interest rates.

To come back to the point made above, if a sluggish stock market acts as a deterrent to inflows in the year ahead, there could well be pressure on the balance of payments. While the probabilities of this happening don't seem high at the moment, the eventuality should not be dismissed. However, whatever happens on the balance of payments front, the tightening supply of liquidity is a given. Interest rates were rising as a consequence of it and the RBI's hike will reinforce this tendency.

Will this result in a slowdown in the growth of investment and consumer spending? On the investment side, it will reinforce the disincentives inherent in slowing profit growth. On the consumer side, however, the sheer numbers of first-time buyers of houses, cars and motorcycles and the ability of lenders to offset higher interest rates with longer repayments may keep the momentum going. Overall, a moderate negative impact on growth is the most likely outcome.

To sum up, as things stand today, there are several reasons to expect that growth during the next year will not keep pace with the current year. There are, however, adequate buffers in several key macroeconomic parameters, which should be able to absorb the shock of moderately slower growth. After three successive years of good growth, the next year will be disappointing, but by no means tragic.

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