The October slowdown may not be a blip

The growth of the Index of Industrial Production has showed a fall from 11.3 per cent in September to 6.2 per cent in October this year, and from 9.8 per cent in same month a year ago. This is despite three big festivals that we had in the month of October.

The question that struck all economic analysts is whether this fall was just a blip or a sign of downward movement in the industrial cycle, which has been moving upwards for almost four years. And this is the longest cycle that we are experiencing in the reform period.

Given the current strong positive sentiments on the Indian economy, it would be easy and wise to say that this fall is just a blip and the industrial performance would be back to its high growth path. But to say that the industrial growth has reached its peak in the current cycle and the only way is to move downward, following the cycle, one has to be a skeptic.

Although I don't wish to be a doomsayer, there are some valid reasons that lead me towards that direction. In my institute's regular publication, Monthly Monitor, I have been saying for some time that there could be a slowdown in industrial growth any time.

One stylised fact, before I present the skeptical thoughts, is that the current industrial growth cycle is yet to reach to its peak that we experienced in 1995-96. Hence, there is a reason for further upward move in the industrial growth path.

It may be noted from the accompanied graph, where we have presented monthly IIP growth (from 1994 to October 2006) and a thick line that explains the broad cyclical movement in IIP growth (based on the actual IIP growth data and the forecasts up to the middle of 2007), that our econometric model shows that there could be a turning point downwards in the IIP growth cycle in the near future, if not from next month.

Hence, one reason for the expected slowdown could be the business cycles. In the recent period, Indian economy has been increasingly integrating with the global economy in terms of both financial and goods market.

Hence, the presence of strong business cycles, following the world's growth (which is expected to move downwards according to World Bank's estimates), may not be surprising.

The other domestic factor that could cripple the industrial growth is the tightening of credit (through rising risks) to the housing sector. To understand the spin-off effect of this, it is necessary to understand the recent trends in the US housing sector and its linkages to other sectors in the economy.

It is simple to understand that the "core group" of the industrial sector depends on the housing sector and the linkage between the core and non-core groups of the industrial sector is strong.

Hence, any adverse impact on the core group would lead to an overall industrial slowdown. Now in India, following the international interest rate cycles, the RBI has adopted a tight monetary policy. With this, other commercial banks have hiked (and continue to hike) their interest rates on retail loans and also their deposit rates.

Past studies on India concluded that the interest rate channel of the monetary transmission mechanism is weak, and the credit channel is stronger than the interest rate channel.

This conclusion, in my view, might not hold good now as the determinants of interest rates have changed in the recent times and also seen structural breaks in most of the financial variables in 2002-03. As in any emerging economy, in India also the real economic response to interest rate changes should have become more significant in the recent period.

Hence, the hike in interest rate structure may lead to a slowdown in the industrial output in the coming months.

A look at the non-food credit to the commercial sector provides that there is a decline in its growth in the current year compared to the previous year. Even the total credit (both to the commercial and government sectors) has also declined marginally in the current financial year.

Another striking issue is that the credit to government, which was negative for quite some time, is growing at little above 4 per cent. At this juncture, one needs to make a well-informed judgement whether the credit to government would have a crowding-out or crowding-in effect on private investments, depending on the expenditure pattern of the government.

As per the information available from the media, until now the productive sectors have seen no significant investment. Rather the expenditure seems to have increased on populist schemes and on activities that strengthen human development, which increases productivity with a significant lag. Hence, the rise in credit to government mostly should have a crowd-out effect on private investments.

There is a demand side story, too. From the recent performance of exports, it is quite obvious that this year's industrial growth has been substantially contributed by external demand.

Now that the world economic growth is expected to slowdown, sustaining of current external demand into 2007 is in question. The domestic demand is also expected to slowdown given the hike in domestic interest rates (on deposits) and also due to the rise in inflation.

Insignificant festival demand on output in October means that there seems to be a shift or slowdown in the spending pattern among the great Indian middle-class. Overall, the demand side story is also not supporting the future high industrial growth.

Now the issue of "overheating" means a rising inflation rate on the back of high output growth, which we are experiencing now. As it appears, the inflation for the current fiscal year could settle in the RBI's predicted range of 5-5.5 per cent, which is high. (The inflation rate based on CPI [IW] is more than 7 per cent!) The only way to "cool" is to follow a tight monetary policy, which the RBI did last week by hiking the cash reserve ratio.

Further, it has been mopping up the liquidity from the short-term money market for quite some time. As we predicted way back in middle of 2005 (presented in Monthly Monitor) that the current interest rate cycle would peak by the end of 2006, it is turning to be true.

In my view, the RBI might further fine-tune the policy by hiking the interest rates in such a way that it can contain the inflation rate by forgoing a marginal growth in output.

As predicted earlier, we reiterate that with this hike (although this should have happened in the last round of monetary policy review), the interest rate cycle would peak.

All these force me to accept, although hesitatingly, that the current upward industrial growth cycle will see the turning point. But the question remains when it would turn. In November and December 2006, the IIP growth, as expected by many analysts, could come back to the high growth path. But that would be due to low base in these two months. One needs to look at the January 2007 figures, which will answer our question.