The surge in foreign capital inflows that fuelled the Indian economys high growth trajectory is also making it fragile and vulnerable to financial crises elsewhere.
AN appreciating exchange rate, stock market volatility and global pessimism are yet to affect Indias growth story. Figures released by the Central Statistical Organisation at the end of August indicate that gross domestic product (GDP) grew by 9.3 per cent during the first quarter (April-June) of 2007-08 when compared with the corresponding quarter of 2006-07. This is the sixth of the last seven quarters in which the annualised GDP growth rate has exceeded 9 per cent, the exception being the third quarter of 2007 when growth fell short of that target by just 0.3 percentage points.
The quarter-on-quarter annual GDP growth rate first crossed the 9 per cent mark in the second quarter of 2003-04 and has remained above that level in 10 of the 16 quarters since then. Restricting the analysis to the current series of national income statistics with 1999-2000 as the base, we find that in the 13 quarters prior to that (starting with the first quarter of 2000-01), the GDP growth rate never crossed the 6.7 per cent mark and stood below 5 per cent in five of those annual comparisons.
In the event, if we make a crude comparison of averages of quarterly growth rates for the two sub-periods starting with the first quarter of the financial year 2000-01 and the second quarter of 2003-04 respectively, India appears to have traversed from a rate of growth averaging 4.8 per cent to a rate of growth of 8.8 per cent (Chart 1). In sum, the country seems to have experienced a sudden boost in the middle of 2003 that resulted in a more than 80 per cent increase in its average quarter-on-quarter GDP growth rate.
While celebration over this remarkable transition to a new growth trajectory continues, convincing explanations of this statistical trend are difficult to come by. One route to arrive at an explanation, however tentative, is to search for sectoral drivers of growth in overall GDP. There are a number of features of the sectoral composition of growth that need noting. To start with, the widely held perception that the agricultural sector (broadly defined to include forestry and fishing) has not been part of Indias growth transition is corroborated by the data. Agriculture has languished at a time when the trend rate of growth has been rising.
The divergence in growth rates of overall and agricultural GDP has persisted and even widened after the 2003 breakpoint, even though the volatility in agricultural growth rates has fallen since then. While agricultures share in aggregate GDP averaged more than 21 per cent during this decade, its contribution to the quarter-on-quarter absolute increase in GDP has remained below 10 per cent in most recent quarters.
The second, much-noted feature is that services seem to have played an important part in Indias growth story. Services GDP has grown faster than aggregate GDP for most of the period since 2000. What is more, there appears to have been acceleration in the growth of services GDP during the second of the two sub-periods being discussed. In most quarters since 2003, services have contributed between 50 and 65 per cent of the quarter-on-quarter increment in GDP.
However, a disaggregated analysis suggests that it is only one component of the services sector financing, insurance, real estate and business services that appears to have contributed to the acceleration in GDP growth. The rate of growth of this segment has been accelerating since the middle of 2002. On the other hand, the growth rate of the other important segment of services trade, hotels, transport and communications though higher on average in the second sub-period, has shown no sign of any significant acceleration.
Fourth, in a less noticed development, the sector that appears to have contributed significantly to the growth transition is manufacturing, which has seen a sharp acceleration in annual rates of growth between the first and second periods. It has also registered a significant and consistent increase in its contribution to the annual quarter-on-quarter increment in GDP. This less recognised aspect of the growth story signifies a shift away from the excessive dependence on services to generate increases in Indias GDP growth.
Overall, therefore, the evidence seems to suggest that financial, real estate and business services and manufacturing are the two sectors that have driven Indias transition to a higher growth trajectory. Four questions arise: What has been the relative importance of exports and domestic demand in explaining the transition? Is the simultaneous role of finance and manufacturing as growth drivers coincidental or related? If related, what is the mechanism by which their interaction translates into higher growth? And, if this mechanism did trigger the transition, why did it come into operation when it did?
Export revenues have unquestionably contributed to the expansion of the business services sector, which includes software and IT-enabled services. But manufactured exports have also played a significant role. The average growth rate of the dollar value of merchandise exports from India rose from 13.2 per cent in the 2000-01 to 2002-03 period to 25 per cent in the 2003-04 to 2005-06 period.
Sectors under manufacturing that have contributed to this recovery include chemicals (17 to 25 per cent), manufacture of metals (15.2 to 31.4), machinery and instruments (19.7 to 33.7) and transport equipment (18.7 to 50.9). However, while this step up in export growth has contributed to the acceleration in manufacturing growth rates, the small share of exports in manufacturing production still gives domestic demand an important role in explaining the growth recovery.
Domestically, the simultaneous boom in finance and real estate on the one hand and manufacturing on the other is not fortuitous. The financial boom is based on an increase in liquidity in the system, which has permitted a sharp increase in credit provision and ensured a relatively low interest rate regime.
This has, in turn, triggered a boom in the real estate sector, driven by a sharp increase in housing finance and lending to and investment in the real estate sector. Thus, within the finance and real estate subsector there are internal linkages that deliver a rapid increase in GDP based on easy finance.
But easy finance impacts on manufacturing, too, in two ways. First, it results in a credit-financed housing and consumption boom that significantly steps up manufacturing demand. And, second, profits derived from the credit-financed manufacturing boom are much higher than would have otherwise been the case because of much lower interest costs. Higher profits in manufacturing trigger, in turn, an investment-led boom in that sector.
Thus, the Indian economys sudden transition in mid-2003 to a higher growth trajectory, while influenced by a revival in exports, was driven in the final analysis by a financial boom that eased credit availability, reduced interest rates and encouraged debt-financed consumption and investment. But why did this financial spur occur when it did? The timing was influenced by factors external to the Indian economy that resulted in a surge in inflows of foreign capital into developing countries around 2003 and since.
India benefited disproportionately from those flows because of its liberalised investment environment, relatively good economic performance and the concessions offered to foreign investors, including the abolition of the long-term capital gains tax in the Budget for 2003-04.
The resultant liquidity overhang created the environment that facilitated the growth transition.
However, this role of capital inflows in placing India on a new growth trajectory also makes that growth process fragile for reasons that have become clear in recent months. One source of the fragility is the continued appreciation of the exchange rate of the rupee despite the efforts of the Reserve Bank of India to stall such appreciation. Signs are that rupee appreciation is reducing the competitiveness of Indias exports and weakening the export stimulus that contributed to an improvement in both services and manufacturing growth.
The other potential source of fragility is the threat of a liquidity crunch because of an outflow of foreign capital for reasons unrelated to Indias economic performance. Dependence on foreign capital flows has made India vulnerable to the contagion effects of financial crises elsewhere, such as the subprime crisis in the United States. A consequence of that crisis is a tendency by foreign investors to sell out assets acquired in India and repatriate the receipts so as to cover losses and meet commitments in the U.S. and elsewhere.
That prospect is resulting in a degree of uncertainty in Indias real estate market where foreign investors have been important players in recent times. Their exit could slow or stall the expansion of the real estate sector. The exit of foreign investors could also absorb much of the liquidity in the system, adversely affecting credit availability in the Indian market and pushing up interest rates.
If that happens, the spur to growth provided by easy finance would also be weakened. These tendencies, though visible, have yet to slow Indias rapid growth substantially. But if they gather strength the impact on growth could be adverse.
This is the inevitable outcome of Indias indirect dependence on foreign capital inflows to ensure its transition to a new growth trajectory.
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