Recent index of industrial production (IIP) data seems to have surprised many analysts, who?s median forecast for January 2008 was above 7%. But this was not a surprise to us, as our forecast was closest to the actual figure. Overall growth in April-January has also declined to 8.7%, against 11.2% in the same period last year. This is quite contrary to the expectations of high industrial growth assumed in Budget 2008-09. This raises two questions: first, is it the beginning of a new industrial recession? Secondly, what are the factors for this, if at all, recession and what could be the possible policy response?
There may be many reasons for the current industrial slowdown. First, one needs to understand that the current cycle of high industrial growth, which has continued since 2003-04, has been the longest in recent times. Hence, any slowdown in output is inevitable and could be largely attributable to the downward movement of the industrial cycle. This cyclical trend was also seen in our forecasted IIP growth data (using the Hodrick-Prescot filter). Secondly, rising world oil prices, which recently touched an all-time high of $111 per barrel, could also be a factor for the declining industrial sector, through an increase in the cost of production. High oil prices also mean that industrial nations might want to export more and this, in turn, would hamper domestic production.
Third is the decline in both domestic and external demand. In the recent times?as reflected in export growth in rupee terms?there has been a decline in external demand following a slowdown in the world economy, in particular the US economy, which is staring at recession. The decline in the production of consumer durables, which is a leading indicator of additional domestic demand, shows that there is fall in domestic demand as well. (Consumer durables goods growth in April-January 2008 was?1.7% against 10.6% in the same period last year).
Similarly, the production of capital goods also leads to industrial cycles. If industry fears demand recession, then it slows down the production of capital goods. Similarly, a recovery begins with an upsurge in capital goods production. The recent use-based classification data of IIP reveal that the growth rate of capital goods declined sharply to 2.1% in January 2008, after sustaining double-digit growth for more than a year. This further confirms that industry is actually anticipating a recession. The current positive growth in industrial production is almost entirely due to consumer non-durable goods.
Now, possible policy options to prevent a sharp fall in industrial sector growth are debatable. Many economic analysts and industry bodies are arguing for a cut in policy interest rates by the Reserve Bank of India. A number of studies, including ours, have shown that the interest rate channel is weak in India.
Rather, it is the credit channel that is stronger, and stimulates growth. This means there is a weak relationship between interest rates and real investment demand or credit off-take. Any changes in interest rates would have a larger impact on inflation and not much on real economic activity.
At this juncture, it is also important to recall that we have seen an industrial boom in the late 1990s when interest rates were at its peak and recession in 2001-2002 when interest rates were moving southwards. Hence, there are reasons to call for a rate cut only if it will help industrial growth. This is not supported by empirical results.
To contain the downward movement in the industrial cycle, there is need for policies that are counter-cyclical and lead to an increase in domestic consumption demand. The recent Union Budget 2008-09 has indeed rightly addressed this issue. Policy measures such as the loan waiver, hiking tax exemption limits, and reducing customs & excise duties are expected to enhance domestic demand. In addition, the forthcoming Sixth Pay Commission award is also expected to create additional domestic demand and could reverse the industrial slowdown.
But on external demand, it would largely depend on the extent of the US economic recession, which appears to be larger than anticipated. In addition, the existence of inflationary pressure means we may need to ride the downturn in the industrial cycle for some time.
The writer is associate professor, Institute of Economic Growth, Delhi
e-mail: bhanu@iegindia.org