Economy: Back to the future! - Views on News from Equitymaster

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Economy: Back to the future!

Dec 28, 2006

The Indian economy has never had it so good. With a strong GDP growth momentum sustaining over the past 14 quarters (since July 2003), and consumption demand not showing signs of a slowdown, one would be forced to believe that we are living in utopian times. As a matter of fact, for the last eight quarters on a trot, the GDP growth has never been below 7.5% on a YoY basis. Construction, housing, hospitality, transportation and manufacturing, among others, have all chipped in with their contribution to aid the growth process.

However, in the entire process, we have come to feel the vibes emanating from the policymakers and economists that the economy is showing signs of overheating, led by cheap money (global and local), borrowing binge, unequal improvement in productivity, and the consequential rise in inflationary pressures. As per the latest review of CMIE (Centre for Monitoring Indian Economy), an economic think-tank, inflation, as measured by the Wholesale Price Index (WPI), rose to 5.45% by the middle of November, thus touching the upper limit of the RBI's inflation tolerance band of 5.0% to 5.5% for 2006-07.

On the money supply front, there have been actions from the Reserve Bank of India (RBI) in reining this inflationary pressure. During the second week of December 2006, the central bank increased the cash reserve ratio (CRR) by 25 basis points to 5.25% with effect from December 23, 2006. There is another 25 basis points hike in the CRR scheduled on January 6, 2007, which shall take the rate to 5.5%. As reported, the said hikes in the CRR are expected to absorb around Rs 135 bn (US$ 3 bn) from the financial system, thus acting as a reining mechanism for the unsustainabe high growth in credit offtake. As reported by the CMIE, annual growth in money supply stood at 18.7% as on November 10, 2006. Although the growth has decelerated from the 19.9% growth in money supply seen in August 2006, it is still significantly higher than the 17.2% growth recorded in November 2005.

Now, there are pressures on the external front as well, as seen from the continuous deterioration in India's trade balance. During the first seven months of this fiscal (2006-07), India's current account deficit has touched US$ 30 bn, which is higher by US$ 5 bn over the deficit recorded in April to October 2005.

Conclusion
We believe that the three key macro factors of demographics, globalisation and economic reforms, which have led India's strong economic performance during the past three years, shall continue to pump the economic activity in the country going forward as well. However, there is caveat to this assumption. While we believe that these factors will aid the economy's strong performance in the coming years, the fact that a part of growth in the past has been a result of the sharp rise in capital flows (in response to an increase in the global risk appetite), which has allowed the government and the RBI to pursue relatively loose fiscal and monetary policies, puts the economic growth to a test of risk. The Indian economy also needs to move faster on the infrastructure investment front while controlling the rampant growth in consumption.

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