The last couple of years were marked by an apparent disconnect between the real and financial sides of the Indian economy, especially when it came to the impact of shocks emanating from one side of the economy on the other. The stock market was moving up and down its roller coaster during the last two years, even as investment activity remained charged up. Interest rates were climbing up for almost two years, but again, there was no let up in investment or consumer spending. The rupee was appreciating, but it did not significantly affect export growth. Sure, credit offtake appears to have slowed somewhat, but more recently, and with little noticeable impact on industrial production. The established economic relationships suddenly look weaker than before. Of course, China has long battled all international market volatility?financial or otherwise?with no perceptible fatigue or scars on economic growth.
There are indeed lags and leads in economic relationships, and one may still find that the expected consequences of changes in the financial side to the real side would finally show up. However, one important reason for the muted response of the real side to financial side shocks appears to be the significant and unexpected scope for greater efficiency in operations. A more visible factor modifying the speed and nature of adjustment is the globalisation of the economy.
Consider the impact of exchange rate appreciation on the rupee. The main effect has been on the profit margins of exporters. Those who import their inputs benefit from a reduction in costs to that extent. For others, probably, there were opportunities in improving efficiency and raising volumes to make up for lower margins. Moreover, firms may also have chosen to move up the value chain to improve their margins.
Did that happen? We still do not know, but if exports have not registered a major setback so far, then clearly one or any combinations of these options were exercised by Indian exporters. Not all exporters, of course, are as lucky as those exporting petroleum products for whom higher prices would have offset the rupee’s strength. An important way in which cheaper imports, because of a stronger rupee, may have influenced the overall economy is through the petroleum sector. The high international oil prices turn the argument hypothetical, but if these prices were steady, a stronger rupee would have benefited many sectors. The disconnect, then, is the greater efficiency of exporters.
Why has investment spending remained high even when interest rates have increased? Have higher interest rates, without any decline in the availability of funds, done no more than increased the cost of capital for investors and therefore merely raised investment risk? The capital inflows have kept the financial tap open for those willing to invest. Firms with their own funds clearly see return-on-investment today far more attractive than postponing investment till later. Access to global finance, even for a few, has meant that the volume of investment that can take place at higher interest rates is far greater than before. It is not the rationing of finance at higher interest rates that is limiting investment today, but simple calculations of returns. At least in this sense, globalisation appears to have weakened the relationship between investment and interest rates.
The relationship between inflation and consumption spending is often seen to be tenuous because of the low average income levels at which consumption spending is inelastic with respect to prices. The continued strength of consumer spending seen in terms of the production growth of consumer goods even under inflationary conditions, as observed last year, is striking. Until interest rates in India began to rise, even the demand for housing and housing loans did not show any deceleration when the inflation rate was moving up. In fact, the growth of consumer goods production may not even fully reflect consumer spending in the country. Imports, too, are playing an important role in meeting consumer demand. In other words, access to international markets, where the price rise may be lower, has expanded the purchasing power of the Indian consumer. Financial markets have also expended, but may be influencing only some specific markets?as in the case of automobiles?from the shocks of spikes in the inflation rate.
The frequency of financial sector shocks to the economy emanating from global markets will, naturally, keep our attention focused on the implications of globalisation to the domestic economy. But, unnoticed, the real sector of the economy is getting globalised quickly as well. When we consider manufactured products, for example, the role of international markets is evident. Merchandise exports now account for about 15% of GDP. As the bulk of merchandise exports are manufactured exports as a proportion of manufactured products output, exports will be a fairly large chunk. The imports are also a significant proportion of demand for manufactured products. Not surprisingly, globalisation, whether in terms of imports or greater access to finance, is emerging as the missing explanation that captures the greater flexibility of responses by economic actors in India.
?The author is senior research counsellor, NCAER. These are his personal views