The optimists still argue that 8% growth for India is achievable even now given the strengths of the domestic economy, that Indias duration of pain will be relatively short, and that the economy could bounce back strongly as early as in the next financial year. But the optimists could be missing the basic conditionality that had allowed India to register such sharp growths. Domestic consumption and investments both saw sharp rises, but investment demand was especially strong in the five-year period starting FY04. Gross fixed capital formation as a percentage of GDP was growing at 6.6% in FY03 but jumped to grow at 13.7% in FY04 and averaged 15.8% in the five-year period ending FY08. On the other hand, consumption expenditure growth averaged 6.7% in the same period.
The story of private consumption was largely based on the wealth effect that the stock market generated, which allowed for the confidence with which Indian consumers could open their purse strings. Low levels of interest rates helped. Prices of all asset classes rose, mainly in equity and real estate. There is now a reversal of this scenario. The sharp deterioration in the global economy and the consequent outflow of foreign funds have led to a significant erosion of the wealth effect. The generally sticky lending rates of the banking sector are on the downside, despite monetary easing.
The risk is that the dip in the consumption spending can spread beyond conspicuous levels into normal levels of consumption. Definitely kapda is not conspicuous consumption though buying of designer clothes could be. Today I would possibly be buying only one shirt instead of two, and would like to sustain this one piece longer than I was previously doing. This is reduction in demand. The general fear of job loss would be on top of everyones mind, including in the BPOs and KPOs that employ a large chunk of Indias younger workers. Barack Obamas win could dash the career hopes of many such young Indians due to his fierce anti-outsourcing stance. Can we blame him With the US economy now fighting unemployment, there would obviously be limited enthusiasm for sending jobs out of the country.
A significant portion of investments was financed by foreign funds, FCCBs and ECBs. It will be some time before these avenues once again become viable funding options. First, the global financial institutions are themselves in a de-leveraging mode. Anecdotally, even a large company from India could be able to raise funds globally at around 600-800 bps over LIBOR, a spread that is still not allowed by regulation even after significant relaxations in Indias ECB policies. Second, the whole definition of risk capital is likely to undergo a sea change with greater regulatory holds on global financial institutions. Thus it could be some time before capital moves back into emerging market economies such as Indias. Third, the overall savings potential of the Indian economy will be lowered by a higher fiscal deficit, lower private sector profits and lower levels of disposable income in the hands of the working population.
Thus investment demand is likely to suffer significantly. Projects not yet started will possibly be shelved while projects that are mid-way will create a huge pressure on the shrinking rupee resources. Even after large doses of monetary easing by the RBI, the borrowing rates of companies are unlikely to come down immediately. Further, risk-averseness will be the order of the day so far as lending activities are concerned. And this is likely to bring down capital expenditures sharply.
For the current fiscal, we could still grow at around 7%, (though with a downward bias), but bigger pains may be awaiting India in the coming fiscal. With elections around the corner, big bang fiscal decisions would have to be held back. But Indian companies today have better sizes and balance sheets to sustain weaker demand for longer than they could in the previous slowdown cycle of 1994-96. Indias reforms process has definitely led to structural changes that would prevent Indias GDP growth from dropping to 3-4%. A sustainable level appears to be around 6-6.5% for a few years to come.
The author is chief economist, Kotak Mahindra Bank. These are his personal views