What caused the fall in the Index of Industrial Production in October 2008? It fell by 0.4% compared to its level a year ago. It is unusual for the IIP to fall. This was the first fall in the Index in over 14 years. Growth in the IIP has been weak in 2008-09. And, even before the release of the October IIP estimate, there was a steady stream of depressing data releases regarding October. Exports had declined by 12%, truck sales had fallen by over 30% and traffic on the major ports had declined by 5.7%. Yet, the fall in the IIP was a bit of a jolt. It is too important as an indicator and therefore its fall raises worries that have a greater significance than the fall in say, automobile sales. Are we headed for a general all-round slowdown or was this a local problem associated with the events of the Global Liquidity Crisis around September-October?

If the IIP had fallen because of a fall in domestic demand then, it reflects a serious problem in the economy. This fall in domestic demand may have been caused by the sustained increase in interest rates engineered earlier by RBI. It seemed to be apparent that this could have been the reason for the fall in truck sales and also the slowdown seen in the real estate sector. But, was this now afflicting the rest of the industry?

Alternatively, October fall in the IIP could have been caused by the global liquidity crisis (GLC) that emerged in late September. This could have had an impact on domestic demand in October. There was a fear then of large scale job losses, companies closing down either because they would lose orders in the West or because there was simply no money around to run business. All these factors could severely hurt domestic demand.

If RBI or the GLC or a combination of the two did indeed cause a slowdown in domestic demand then, this slowdown would be long lasting. More importantly, if domestic demand was adversely affected by the expected halt in creation of fresh capacities, shutting down of existing capacities and consequently a fall in jobs, then this is more of a long term problem. As a result, the IIP would continue to decline till the cyclical downturn runs its full length. The last time this happened was in 1997 and the slowdown had lasted for six years.

There could be a third reason why the IIP fell so sharply in October. It is quite likely that domestic demand was fundamentally unaffected. The fall of October was a supply-side failure caused by the Global Liquidity Crisis. One element of the GLC was that it broke down international trade finance and therefore international trade. This showed up almost immediately in the fall in India?s export and in the fall in traffic on major ports. This fall in international trade had a direct and immediate impact upon the portion of India?s industrial production that was closely linked to international trade. The fall in demand in the US and the expectation of a fall in demand following the GLC, had an immediate impact upon India?s export-led industries.

Thus, by this reasoning, the IIP should have fallen essentially in the export-led industries and should have done quite well in the domestic-demand industries. Ajay Shankar, Secretary, Department of Industrial Policy and Promotion, suggested that this hypothesis be tested by using the October IIP data. I have always been sceptical of the quality of the IIP data but argued that the quality of the IIP is uniformly bad across all sectors.

The findings were stark. Industries that were essentially dependent upon domestic demand did quite well. They grew by a robust 12.6% in October. And, those that were essentially export-demand driven tanked by 9.5%. Sectors that were dependent upon a mix of export and domestic demand fell by 7%. We measured the automobile and real-estate related sectors separately as these, it was expected, would be the ones that were more affected by the increase in interest rates in the domestic economy. The performance of both these groups of industries was not too bad. They grew by 6.3 and 6.2% respectively during October. Thus, their performance was not as bad as that of the export-demand driven industries and was not as good as those of the domestic-demand industries.

So, what does this mean for the future? Firstly, this means that domestic demand is safe. It remains unscathed by the GLC. Given that domestic demand accounts for over 60 per cent of GDP, this bodes very well for the economy in 2009-10. Second, the RBI?s policy to curtail domestic demand had (fortunately) only a very limited impact, essentially the housing and automobile sectors. Thirdly, export-led industries are likely to face adverse conditions for some time.

The most important inference from the above is that the fall in the IIP in October was to a great extent a one-time supply shock caused by the momentary failure of the global financial markets. RBI?s quick action to infuse liquidity into the system and the general signal by the government that liquidity would be infused if required has, over the past three months, repaired the damage caused to the domestic economy by the GLC. The IIP is expected to continue to suffer during November and December when the effects of the GLC lingered. However, it should recover from January 2009 as the government?s efforts to repair the damage take effect.

?The author heads the Centre for Monitoring Indian Economy