The Congress victory has generated immense optimism for the outlook for the economy. How should the new finance minister, Pranab Mukherjee, take advantage of this? Take stock of where we are in terms of business cycle conditions and then change private corporate sector?s mood. Just as Manmohan Singh did in 1991.

What drives Indian business cycle fluctuations?

The most important determinant of business cycle conditions in India is private corporate investment. The chart shows what has happened to private corporate investment, as percent of GDP, from 1989-90 till 2007-08. This data is not available for 2008-09 or 2009-10.

The economic reforms of the early 1990s got private corporate investment up from the region of 4% to a peak of 10%. This six percentage point increase of private corporate investment generated a strong business cycle expansion.

The decline of private corporate investment back to values like 5% was the essence of the business cycle downturn of 2001-2002. After this, we have seen an immense expansion of private corporate investment?all the way to 16%. This is the essence of the benign business cycle conditions of recent years.

The most important question that will shape business cycle conditions in 2009-10 and 2010-11 is: by how much will private corporate investment decline? It is important to see that today, each percentage point of GDP is Rs 55,000 crore, so we are discussing massive numbers. If a decline of private corporate investment takes place from 16% to 10%, then this is a reduction of demand by 6 percentage points of GDP or Rs 330,000 crore. When private corporate investment goes down, the overall impact on GDP is magnified through multiplier effects.

The shocks to GDP that are generated by these fluctuations of private corporate investment are so large that monetary or fiscal policy, as presently organised in India, can simply not counteract them. The only place where public policy can make a difference to this is to identify the policy instruments through which private corporate investment can flourish.

What has happened in recent months?

From this backdrop, we now turn to information from recent months. A key flaw of data handling in India today is the use of year-on-year growth rates. The change from February 2008 to February 2009 is the sum of 12 changes, one per month. If we are interested in recent events, it is more important to look at the change of each month.

These month-on-month fluctuations can be distorted by seasonal effects. As an example, prices are likely to go down in October because the harvest comes in. Hence, what is required is seasonally adjusted month-on-month changes. We have implemented these procedures for many Indian monthly time-series of interest.

How have global conditions adversely affected the domestic economy and particularly private corporate investment? Two channels are at work. The first is export demand. Non-oil exports growth has been negative from July 2008 onwards. Seasonally adjusted non-oil exports (expressed in rupees) declined in each month from this date onwards.

The second channel is the profitability of the tradeables sector. For a large number of goods?such as steel?the domestic price is now the same as the world price, reflecting India?s new-found trade integration with the world economy. Hence, soft economic conditions worldwide are propagating into India, yielding reduced prices of tradeables, reduced profit rates and thus reduced investment in India. The WPI manufacturing is a good measure of what is going on with tradeables. This has shown deflation (i.e. decline in prices) for every month from September 2008 till February 2009.

Non-food credit is an important indicator of how the economy is faring. In the business cycle expansion, annualised growth rates of 15% to 25% were prevailing. These ebbed away to 14% in October, 7% in November, 2% in December and 0% in January. Growth improved slightly to 7% in February.

The problem of private corporate investment…

Good monthly data on investment is not available. But the above factors suggest a gloomy environment for investment demand, particularly the investment by companies producing tradeables. It is important to see that what we have experienced is not just an October/ November shock. Exports have shrunk in each month from July 2008 onwards. Tradeables? prices have declined in each month from September 2008 onwards. Each month, conditions have become worse than in the previous month. In thinking about this, it is particularly important to focus on month-to-month changes as opposed to the 12-month moving average which year-on-year changes show. Conditions with non-oil exports, WPI manufacturing and non-food credit are all at levels comparable with those found in the crisis of the early 1990s.

What determines fluctuations of corporate investment?

Investment is critically about ?animal spirits?. CEOs build factories when they are feeling optimistic about the world (and vice-versa). As the graph shows, private corporate investment surged after confidence was created that India was on the right track in economic reforms. Once an expansion commences, it tends to feed on itself, but policy triggers are of critical importance in inducing turning points.

With conditions reminiscent of the early 1990s in terms of an economic downturn, it is fitting to emphasise the importance of a budget speech comparable to that which Manmohan Singh as finance minister delivered on 24 July 1991. If this speech is able to break with the stasis of recent years, and put economic reforms back on track, it would be able to stave off the scenario of a sharp decline in private corporate investment. If, on the other hand, the coming budget speech is not seen as a leap forward for economic reforms, then business cycle conditions may appreciably worsen in 2009-10.

?The author is a noted economist with interests in pensions, finance and macroeconomics