The threat of recession

If the slump in growth rate witnessed in India during the second half of the 1990s persists into the first half of the present decade, the economy could be afflicted by a severe industrial recession soon.

RECENT announcements from the Central Statistical Organisation (CSO) regarding trends in the index of industrial production (IIP) point to a significant slowing of growth in the registered industrial sector in India. The provisional estimates of the IIP for November 2000 released recently by the CSO suggest that industrial growth during the first eight months of fiscal year 2000-01 (April-November) fell to a low of 2.2 per cent from the not-too-creditable 5.7 per cent during the corresponding period of the previous year. If this trend persists, the overall trend rate of growth during the decade 1991-92 to 2000-01, which was the decade of accelerated economic reform, is likely to be worse than that of the preceding 10 years.

Going by the CSO's most recently revised figures, the trend rate of growth during the period between the 1991-92 and 1999-2000 was, at 6.7 per cent, the same that between 1981-82 and 1990-91. However, protagonists of reform have argued that 1991-92 was an unusual year of adjustment, and should be ignored when estimating the trend rate. But even during the period 1992-2000, the growth rate was only marginally higher at 7.3 per cent, and it is likely to fall significantly for the period between 1992 and 2001, if the annual rate of growth in 2000-2001 remains close to the 2.2 per cent recorded during the first eight months of that year. Thus, in terms of the aggregate rate of industrial growth, there appears to be little difference in industrial performance during the 1980s and the 1990s.

Further, the 1990s have been characterised by significant variations in annual rates of growth. Focussing on the 1990s, the IIP suggests that after falling sharply in 1991-92 as a result of the import compression and stabilisation resorted to by the government in response to the balance of payments crisis, industrial growth recovered quite well, rising to 5.6 per cent in 1993-94, 9.1 per cent in 1994-95 and 12.3 per cent in 1995-96. After that, however, the industrial sector witnessed a downturn, with the rate of growth falling to 6.1 and 6.7 per cent in 1996-97 and 1997-98 and slipping further to 4.1 per cent in 1998-99. There were signs of a recovery in 1999-2000 with the rate rising to 6.5 per cent, but subsequently the pace of growth slackened substantially, standing at just 2.2 per cent during the first eight months of fiscal 2000-01.

In sum, the trend growth rate in the IIP for the 1990s as a whole is not just lower than what was seen during the 1980s, but conceals two periods of sharply divergent trends: a period of recovery and growth during the first half of the 1990s, followed by a period of slump during the second half of the 1990s, which has recently been aggravated, after a brief promise of a possible return to growth. If the trend of the second half of the 1990s persists into the first half of the first decade of the new century, India can expect its economy to be afflicted soon by a severe industrial recession.

If we take a closer look at the years of the downturn, by examining quarterly growth trends (relative to the corresponding quarter of the previous year) in the general index as well as manufacturing IIP for the period between the second quarter of 1995 and the third quarter of 2001, the picture is more complex. From a peak of close to 15 per cent in manufacturing and just below 14 per cent in the case of the general index, growth slumped to less than 3 per cent in the first quarter of 1997. This was followed by a recovery that lasted three quarters, which took manufacturing growth to 9 per cent. But the recovery proved to be short-lived and Indian industry once again experienced a slump until the fourth quarter of 1998. In the next three quarters, there was once again some promise of a recovery, with manufacturing growth touching close to 10 per cent in the third quarter of 1999. But the downturn returned and proved to be much longer and sharper, bringing the growth rate down to close to 2 per cent in the second and third quarter of 2001. The threat of a recession, even if defined stringently to occur when growth is negative in consecutive quarters, now seems real.

The impact of these trends on the major use-based industrial categories, however, tends to differ. It is clear that basic goods and intermediate goods display more or less the same trends as the overall index. The difference really arises in the capital and consumption goods categories. The capital goods sector appears to have been through a longish recovery over the eight quarters between the fourth quarter of 1997 and the fourth quarter of 1999, and then experienced a collapse, with recent trends pointing to a major recession afflicting the sector. The consumer durables sector played a major role in the recovery in 1999-2000 and still appears to be outperforming most industrial categories in the recent quarters. Finally, the consumer non-durables sector has not performed well through most of the latter half of the 1990s.

A caveat is called for at this point. It is well known and widely accepted that the reliability of the IIP declines when we move to more disaggregated levels of industry. Further, there is a substantial degree of overlap between the capital and consumer non-durable categories. Automobiles, purchases of which for personal use rose substantially during the 1990s, are included in the capital goods category. So are electronic goods of certain kinds that would be more appropriately classified as consumer-durables. This overflow of consumer durables into the capital goods category makes it difficult to assess the degree to which any slump or recovery in capital goods is driven by consumer durables. It also implies that the small weight of consumer durables in the overall index does not do full justice to the importance of this sector from the point of view of industrial growth.

ALL this is of relevance when we seek to explain the process of growth and industrial deceleration during the 1990s. When launching the 1990s reforms, the impression conveyed by the advocates of reform was that in the course of time the "animal spirits" of private entrepreneurs would respond adequately to the incentives created by liberalisation. Various elements of the liberalisation programme were aimed at facilitating private investment: the dismantling of government controls on capacity creation, production and pricing practices of even large firms and groups; improved access to imported capital equipment, raw materials and intermediates; easier possibilities of technical and financial collaboration with foreign entrepreneurs; and disinvestment of public equity to private players. It was argued that the stimulus to private investment provided by these new incentives would take Indian industry on to a whole new growth trajectory.

What was not recognised was that the change in policy stance in the 1990s should not just provide the expected stimulus, but that that stimulus had to be strong enough to counter a number of adverse implications of the reforms for manufacturing and industrial growth. To start with, it was inevitable that import liberalisation would result in some displacement of existing domestic production either directly by imports or indirectly by new products assembled domestically from imported inputs.

Second, that the reduction in customs duties resorted to as part of the import liberalisation package and the direct and indirect tax concessions that were provided to the private sector to stimulate investment, especially starting with the Budget of 1993-94, would lead to a significant reduction in the tax-GDP ratio at the Centre by anywhere between 1.5 to 2 percentage points of GDP. This implied that the fiscal stimulus associated with any given level of the fiscal deficit would be lower than would have otherwise been the case. Finally, after some initial slippage in the deficit reduction effort, which took the fiscal deficit to relatively high levels in 1993-94, the government has managed closer, even if not full, adherence to fiscal deficit targets, so that the stimulus provided to industrial growth by state expenditure was substantially smaller than was the case in the 1980s.

This, of course, leaves unexplained the three years of remarkable growth during the mid-1990s. As we have seen, the trend rate of industrial growth during the 1990s was overwhelmingly influenced by the recovery and boom during the three years starting 1993-94. In fact, this three-year mini-boom (as reflected in movements in the IIP) is puzzling for three reasons. First, it cannot be explained by increased fiscal stimulus from the state. It is true that the industrial recovery in 1993-94 was accompanied by a sharp rise in the fiscal deficit of the Central budget to 7.5 per cent of GDP, but the subsequent two years actually saw a reduction in that deficit to 6.9 and 5.9 per cent respectively. Second, the years of high growth were those in which the government vigorously pursued a strategy of import liberalisation and customs tariff reduction, resulting in a large inflow of foreign manufacturers into the Indian market. To the extent that such imports displaced local production, it should have slowed down the growth in industrial output. Finally, those were the years when real interest rates had risen to extremely high levels by historical and international standards. This also should have discouraged industrial investment and therefore the growth of domestic production.

India, therefore, needs to look elsewhere for features of liberalisation that spurred manufacturing production. There is one supply side factor that may have operated in this manner. It has been known for some time that one consequence of the complex of import substitution policies pursued by India till the mid-1980s was the pent-up demand for a range of manufactured goods, including specific brands of such goods. Liberalisation of the kind pursued in India, which freed access to intermediates, components and capital goods while protecting most end-products, along with reducing tariffs substantially, allowed for the expansion of domestic production/assembly and sale of these commodities in a relatively short span of time. This occured at two levels: first, by relatively small firms that combined cheap imports and domestic parts to service what is not always correctly described as the "grey market"; and second, by larger firms, very often in collaboration with international producers with a well-cultivated brand image.

While such products did have a ready market, they would not have contributed to a net addition to domestic production to the extent that they displaced similar or other products in the consumer's basket of purchases. If the availability of new goods were to spur growth, it needed to be accompanied by a net accretion to demand after accounting for the displacement of previously available "substitutes". In the short run such net additions to demand can be financed either with the flow of hitherto unaccounted incomes into the market for goods, or with an element of dissaving reflected by reduced financial savings, or through increased recourse to consumer credit.

THE 1993-1995 "mini-boom" was thus the result of a combination of several once-for-all influences, in particular the release of the pent-up demand for a host of import-intensive goods, which (because of liberalisation) could be serviced through domestic assembly or production using imported inputs and components. Once that demand had been satisfied, further growth had to be based on an expansion of the domestic market or a surge in exports. Since neither of these conditions was realised, industry then entered a phase of slow growth.

It must be noted here that the phenomenon of 'pent-up' demand was not restricted to those who had the wherewithal to realise it as soon as supply-side constraints to their realisation were removed. The tendency existed among other sections as well. As mentioned, financial liberalisation had as its corollary the entry of new financial players into the market and the diversification of banks and non-bank financial companies into new areas of lending that promised higher returns. One such area was lending for consumption purposes, which substantially increased the number of people who could access significantly large sums as credit to make lumpy purchases. Further, the 'windfall gains' registered by a significant number of Central and State government employees as a result of the payment of arrears following the implementation of the Fifth Pay Commission's recommendations, also contributed to an increase in the number of people having the wherewithal to contribute to such demand.

The bulk of such purchases were of consumer durables by households. This explains the consistent performance of the consumer durables sector. And given the overflow of the consumer durables into the capital goods category, it possibly explains the longer boom in the capital goods sector. Put together this could shore up industrial growth in specific years, as for example in 1999-2000, despite the small share of consumer durables in total industrial production. It follows that when such demand is satiated and cannot be sustained any further, the overall tendency is towards slower industrial growth on average if other stimuli such as state expenditure do not substitute for the once-for-all stimulus, as was true by the end of the decade.

THE above argument needs to be clarified. The intention is not to suggest that slow growth is an inevitable consequence of a 'positive' aspect of the reform, which is what fiscal deficit reduction is taken to be. Rather, the stress is on three features. First, the expectation that reforms would trigger the "animal spirits" of private investors, spur private investment and ensure the efficiency of such investment, has been belied.

Second, the belief that liberalisation of import and foreign investment rules would lead to a large inflow of foreign direct investment, which would use India as a base for world market production, has been proven to be misplaced. If such foreign investment had indeed come in large measure in the wake of the reforms, India would have recorded a much-needed expansion in manufactured exports, which would have provided the stimulus for industrial and overall economic growth. In practice, even the additional foreign investment that did come has not been into greenfield projects and has been targeted at the domestic market rather than at export-oriented production.

The third feature is that even though the above expectations have remained unrealised and though conditions have become conducive for increasing state expenditure and triggering growth, the neoliberal obsession of the government with curbing the fiscal deficit has only worsened the problem of decelerating industrial growth.

At present, industry is saddled with substantial excess capacity and inflation is running at historic lows, even as the government has at its disposal large stocks of foodgrains and a comfortable level of foreign exchange reserves. Expanding expenditure, even if deficit-financed, would help expand employment and output and in part contribute to an increase in the tax revenues of the government. Many people have argued that using the foodstocks for a massive food-for-work programme geared to strengthening rural and urban infrastructure is a major growth opportunity available to the government. But its failure to respond positively to such advice has meant that the industrial downturn threatens to transform itself into deep recession.