The beguiling power of first impressions

Last fortnight, we spoke about rising inflationary pressures and the difficulty of balancing the various objectives of monetary management. Since then, the RBI has raised the cash reserve ratio (CRR) by 50 basis points to 5.5% (in two steps) in an obvious bid to tighten liquidity and push up the price of money, that is, interest. The pace of growth in the first half of the year at 9.1% is higher than what the central bank, as well as others, had expected. Rapid growth is enabled by a surge in business confidence.

However, this also has a tendency to generate froth-heightened profit expectations and excessive risk-taking by both investors and financiers. Raising the interest rate and otherwise tightening the screws does inhibit such froth; froth also produces some growth in the immediate term (and headaches and losses later). To that extent in an accounting sense, some growth will be lost. The objective is, of course, to restrict the loss in growth to such unappetising sources, but not to inhibit investment in productive asset creation and other normal economic activities.

There are always certain things which everybody seems to know with an aura of certainty. The fact is that ever so often, the certainty has in it some measure of illusion. For instance, it has been commonplace to characterise the resurgence of economic growth since 2003 as ?consumption-led?. The increasing confidence of the new middle-class and its appetite for personal debt, combined with easy initial liquidity conditions and the support of banks to create an aggregate-demand increment large enough to give us the current boom. Such booms do not, of course, last forever.

Unutilised capacity gets used up and pricing power returns to producers, some not-so-prudent lending takes place under pressure of competition amongst lenders, imports rise faster than exports, and external balances begin to weaken. As domestic liquidity dries up, external finance moves in to pick up the slack. And the general price levels of commodities, assets and labour rise with falling unutilised resource levels. In a sub-plot, the government’s balances can also turn negative as it overestimates future revenues. This, in a nutshell, is what goes under the generic term ?overheating?, a term in popular use today. The problem is that like all analogies, this one, too (in this case, about something left unattended on the stove) is neat, but incomplete.

The phenomenon of the past several years is not quite what everyone seems to have believed. There is an easy way to check out what has produced growth not as a dynamic, but in accounting terms. GDP growth comes from increases in consumption, investment and net external demand (excess of exports of goods and services over imports). In 2003-04 and 2004-05, consumption accounted for 5.2 and 5.0 percentage points, respectively, while investment accounted for 4.0 and 4.2 percentage points of growth. Net external demand contributed 1.5 and 0.4 percentage points to growth.

In other words, while it was not untrue that consumption was a very important component in the increased aggregate demand, this was more than equally true for investment. Remember that during these two years, consumption was 73% and 70%, respectively of GDP. So investment was growing much faster than consumption in order for it to make nearly as large a contribution to aggregate demand. In fact, investment was growing (in constant prices) at 16% a year, while consumption was doing so by 7% annually. In anticipation of the national accounts data due to be released at the end of January 2007, one may suggest that in 2005-06 investment accounted for 4.5 to 4.8 percentage points of growth. In the current year (2006-07), this figure is likely to be up at 5.5 percentage points of growth.

This is thus hardly a tale about consumption-led growth at least by and in itself. There has been a fair amount of investment, too, both in the private and public sectors and 16% annual rates are not so run-of-the-mill, especially when they have been in play for three successive years, not counting 2005-06 and 2006-07. If our estimates are correct, it then will be five years in a row of 16% plus annual rates of increase in real investment. For the record, the average rate of increase in real investment in the two best years of the 1990s, which were 1994-95 and 1995-96, was 17%, with the previous year at 6% and the subsequent one at 1%. Yet, some would like to call the growth boom of the mid-1990s as being ?investment-led?, and the present one as being ?consumption-led?.

This is not a matter of semantics, but the beguiling power of first impressions. In the mid-1990s as the capital goods sector soared as did imports, the investment-element stood out sharply. In the past several years, the boom in automobile sales, mortgage-backed housing purchases, issue of credit cards and (as a result) the big increase in the stock of personal loans extended by the banking industry was the most defining feature. So that took over the reality.

If we look at imports that are meaningful in terms of excess demand or supply (that is, non-oil, non-bullion and non-gem imports), growth has slowed since the second half of the previous year. Now this may be simplistic, but given that the domestic growth rate has picked up in the interim, it does suggest that the domestic supply deficit has at least not grown worse. Perhaps ongoing investment, which many seem to have missed, is making a little difference, and the point is to get it to make more of a difference in the coming years.

?The writer is economic advisor, Icra