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IIP: Interest effect! - Views on News from Equitymaster
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  • Sep 19, 2007

    IIP: Interest effect!

    The Index of Industrial production (IIP) in the economy demonstrated robust growth over the last few years. While the investment cycle slipped in 2001-02 due to high interest rates that affected demand, excess capacity and sluggish employment further led to the decline. However, it has been growing at an average of 8% over the last 5 years.

    The IIP index gauges the investment and the consumption patterns. It consists of four types of goods. The basic goods comprise of metals and mineral ores, while capital goods includes machinery, tools, equipment that go into building other goods. These two are the function of investment demand, which depends on the ease and cost of financing new investments. Thus the interest rate structure determines the growth for these sectors. These two goods combined form 45% of weight of the IIP. Further, when these sectors grow, they raise aggregate demand by increasing the income level of people. As seen from the graph, these two sectors have grown at a CAGR of 23% and 10% respectively over the last 3 years. With lower interest rates, foreign investments and private sector taking the front seat in expansion plans, the capital goods sector has witnessed robust growth over the last few years.

    The intermediate and consumer goods are a function of consumption demand. Increased income in the hands of people leads to an increase in demand for consumer goods. This in turn, leads to the growth in demand for the basic and capital goods after full capacity is reached. Intermediate goods consist of goods that are further modified before they can be consumed, for e.g., chemical, coal and petroleum products and electricity. This sector has grown at 23% CAGR over the last 3 years. The consumer goods sector has grown at a CAGR of 12% and consists of food products, textiles and furniture and fixtures among others.

    There exists a relationship between IIP and interest rates. Interest rates determine the borrowing rate of the companies and the consumers, which in turn leads to the demand for capital and consumer goods. As seen from the graph, an inverse relation exists between the two. With low interest rates, the consumers borrow funds to improve their lifestyle. The demand for automobiles and houses among other things witnesses higher growth. This leads to the growth in consumer goods, which in turn pushes the demand for capital and basic goods. The firms borrow money at lower interest rates to expand capacities. This leads to all the sectors in the economy witnessing good times. With low interest rates, the IIP index witnessed robustness over the last three years.

    However, recently i.e. in the last 4 months, the IIP is witnessing a slowdown. The Central Statistical Organization (CSO) has released a quick estimate of the IIP for July 2007 last week. The IIP rose by 7.1%, as compared to 13.2% in July 2006. This was due to slower growth in the capital goods sector from 18.3% last year to 12.9% YoY. On a QoQ basis the capital goods sector has shown a robust 21.8% growth in the first quarter of this year, marginally higher than the 21% growth last year, which signifies future industrial growth.

    However, the adverse effects of rising interest rates and tight monetary policy are evident. Higher rates have affected the automobile and housing sectors the most. Also the production of machinery and transport equipment and non-metallic products that has cement as a major item has slowed down. Slowdown in investment activity coupled with a lower intake of raw material indicates the slowing in the industrial activity so far this year.

    Going forward...
    The IIP growth for June 2007 has also been revised downwards to 9.0% from the earlier quick estimate of 9.8%. We expect the higher interest rates since the beginning of 2007, to impact capital goods production by December 2007, so that the IIP will continue its gradual slide during the remaining of FY08. When the demand improves thanks to a possible easing of interest rates on the back of lower inflation numbers, the increase in production will come through with new capacities that were added over this latest investment cycle.



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