The 2.6% year-on-year increase in July industrial production, when most expected the contraction trend of past two months to persist, came as a surprise. That this unexpected rebound is driven solely by a 15.6% jump in capital goods growth has led many to conclude the data are one-off; a recovery will be weak and unlikely self-sustaining. However, relating capital goods and exports, which grew at 12-13% in two consecutive months to August, historical patterns portend a self-enforcing, virtuous cycle ahead, largely built upon strengthening external demand, supported by domestic rural consumption.
Investment and exports move in close, positive association at least from the 2000s. At monthly frequency, capital goods growth is in fact, a fairly robust predictor of future exports with a two-three month lead as the accompanying chart shows, using IIP and trade statistics from mid-2006. The strength of the exports-investment relationship also holds when examined from quarterly national accounts statistics (see chart). Gross fixed capital formation growth (GFCF), which reflects the rate at which new assets are created relative to previous years comparative base, co-moves closely with exports growth in more than a decade-long trend.
This isnt as surprising for nearly two-thirds of Indian manufacturing is directly or indirectly linked to exports; moreover, much of the capacity addition in manufacturing during the five-year boom to 2007-08 was geared towards foreign demand. Further, some production capacity, especially in small and medium enterprises segment (about 40% of manufacturing, 30% of non-farm employment), is oriented to both domestic and foreign markets; production in such units becomes viable only at a scale typically provided by export orders. Such is the intensity of investment-export links.
Moreover, the IIP doesnt capture the entire manufacturing sector. Past data revisions are instructive as to the extent of underestimation of manufacturing output as well as its synchronisation with the global business cycle. Consider the hefty revision to 2010-11 GDP growth: This was reworked to 9.3% (8.4% earlier) in January 2013; primarily because manufacturing output was revised upwards by 2.1 percentage points as ASI data (this has much broader coverage than the high-frequency IIP) became available. Then again, GFCF growth for 2010-11 was revised to 14% annually, almost double the 7.5% measured earlier! And capital stock growth contributed 4.2 percentage points to the 10.5% real GDP growth at market prices. It isnt coincidence that global output grew 5.2% in 2010.
IMF has projected global economic growth to rise to 3.8% in 2014 from 3.1% this year while the World Trade Organization (WTO) expects world trade to strengthen considerably in 2014 to 4.5% from 2.5% this year. Assuming external recovery unfolds as anticipated, there is little reason why the investment-export cycle shouldnt be mutually reinforcing. With a 25% GDP share, exports are boosted by a depreciated rupee, which especially favours the IT sector that already projects an optimistic outlook in view of reviving demand in the US and Europe. Other singular measures undertaken recently to encourage exports add to this impulse. Unsurprisingly, the Federation of Indian Export Organisations (FIEO) recently assessed export growth at 24% in the next four months (September-December 2013), based upon order books.
Besides exports-generated effects upon employment and incomes, nearly half of the private consumer demand, i.e. rural segment, will provide impetus next quarter; the base-case prediction for agriculture growth in 2013-14 is 4.5%. This makes up more than half of aggregate demand. And there are lesser reasons why these factors shouldnt unite to create a virtuous cycle of economic growth: This recovery will be predicated upon readjusted fundamentals, i.e. exchange rate and improved fiscal-current account deficits. Inflation risk is relatively low at this juncture: the GDP deflatorthe broadest and a more accurate gauge of overall inflation than the core-inflation captured by the new CPIfell sharply to 5.6% in April-June and by 2 percentage points, reflecting the extent of economic weakness, and which limits depreciation pass-through.
If business demand ahead replicates the historical pattern of export-investment linkages, with global conditions as the key trigger, this will surely test the popular structural narrative of Indias growth slowdown from 2011-12. Stimulation of investment is then more attributable to the global business cycle: Observe the unmistakable co-movement of investment deceleration and slowing exports from mid-2011, a point when US downgrade by Standard & Poors and escalation of Euro zone breakup fears coincided with faltering recovery in these countries. Global output declined from 5.2% in 2010 to 3.9% in 2011.
The facts and past trends would suggest that investment renewal could well be stronger than captured by the IIP data. And its slowdown could possibly turn out to be more cyclical than structural. This may bust many a myth about factors that led to the growth deceleration from 2011-12.
The author is a Delhi-based macroeconomist