India's blossoming economy

Dec 4th 2006From the Economist Intelligence Unit ViewsWire
But there are fears of tough times ahead

The acceleration of economic growth in India recently has generated upbeat assessments that Asia's other giant is finally becoming as dynamic as China, but also warnings that the economy is overheating. With GDP growth in the July-September quarter rising to 9.2% year on year, the headline news is encouraging. But there are crucial differences to the picture in China. Inflation has nearly doubled over the past 12 months. Equity and housing markets look overbought and the current account has moved sharply into deficit. Besides interest-rate hikes by the Reserve Bank of India (RBI, the central bank), little is being done by the government to orchestrate a soft landing.

GDP growth has been above 8% in six of the last seven quarters, and in the first half of the current fiscal year (April-March) it reached 9.1%, the fastest pace since economic liberalisation was begun in 1991. The second-quarter growth figure is better than the Economist Intelligence Unit had expected; consequently we are going to revise our full-year growth forecast (which currently stands at 8.4%) upwards.

That said, the economy is increasingly at risk to overheating, as a number of indicators suggest. The stockmarket has spiked, with the benchmark Bombay Sensex index rising more than 50% in the past year (and fourfold in the past three years). Property prices have soared in a number of cities. And—unlike in China, where inflation remains subdued—the cost of living has been rising at a worrying rate. The rate of headline inflation has nearly doubled in the past year as strong consumer demand, itself buoyed by wage inflation, is putting upward pressure on prices. The wholesale price index showed inflation running at 5.3% in early November, only just off the upper limit for the year specified by the RBI of 5.5%. We expect this limit to be broken, with inflation averaging 5.6% this year.

The RBI has acknowledged the risk of overheating and has been tightening monetary policy steadily, raising its benchmark repo rate (the rate at which the RBI adds funds to the banking system) 100 basis points in the past year, to 7.25%, and the reverse repo rate (the rate at which the RBI drains money from the banking system) 75 basis points to 6%. The RBI's next move will probably be a 25-basis-point increase in the reverse repo rate, to 6.25%, possibly before the central bank's next scheduled official policy announcement on January 30th 2007.

It is debateable whether this alone will be sufficient to ease inflationary pressures, however. The economy is running near or above capacity, and the RBI has noted that production must rise at a pace sufficient to match overall GDP growth if further inflationary pressures are to be avoided. Capacity is rising swiftly—we expect industrial production growth to exceed GDP growth this year and rise by 9.6%—but it is not certain that this can meet soaring domestic demand.

This highlights another difference from China, namely that in India domestic demand, not exports, is driving growth, fuelled by steady wage inflation. This (helped by a fair amount of trade liberalisation) has led to a surge in imports, turning a current-account surplus only three years ago into a substantial deficit in 2006, a swing equivalent to about 4% of GDP. In October the trade deficit hit a record US$6.2bn for the month, more than double the US$2.9bn seen in the same month in 2005. This has exacerbated imported inflation, as have high oil prices (although surging portfolio and direct investment, and high levels of remittances, have mitigated any downwards pressure on the rupee).

There is a case to be made that concerns about overheating are themselves overcooked. Much of the rise in inflation recently can be attributed to short-term supply constraints, such as a shortage of key foodstuffs thanks to an erratic summer monsoon. The government has said as much, claiming that future harvests will ease inflationary pressures (although a lack of investment in the agricultural sector is a long-term problem; in the second quarter agricultural output rose only by 1.7%, year on year, the slowest pace in one and a half years). The soundness of India's banking system means it does not share Chinese-style concerns about the future viability of loans being extended to finance soaring investment (and high credit growth has not had a direct impact on inflation).

However, lured by the prospect of finally catching up with China's growth performance, the government and the RBI are in danger of persisting with an accommodative, growth-oriented strategy that could be storing up problems for the future. Besides the RBI's rate hikes, little is being done to orchestrate a soft landing. The government has tried to ameliorate the rising cost of living by cutting domestic fuel prices (on November 29th), but this has more to do with the need to keep the electorate happy ahead of upcoming elections in four key states than with addressing the underlying causes of inflation.

Future policy is likely to stay accommodative, although a variety of measures—including steps to ease supply-side pressures, moral suasion, or prudential regulations to tame specific sectors—could be employed to lead the economy towards a soft landing. The danger is that if the RBI decides to act more aggressively in future it could trigger a sharp slowdown. Nonetheless, the government is unlikely to do much to jeopardise what Palaniappan Chidambaram, the finance minister, has called "a moment to savour" in India's modern economic history.