Understanding the Faltering National and Global Growth Prospects
Arun Kumar
Economic and Political Weekly, Vol. 43, No. 28. July 12 - 18, 2008.
In the week ending January 5, 2008, the WPI based inflation rate in India was 3.8% and the year was expected to close with a growth rate of 8.5% with the industrial sector growing at about 10%. By April, this rosy picture had undergone a dramatic change. Currently, the rate of inflation has gone up to 11.45% and the latest figures for industrial growth show a slump to about 5%. Trade deficit is rising rapidly. Infrastructure growth has also come down sharply, and various services, like, financial services, software, trade, real estate, air travel and tourism are in the midst of slow down. If this continues, could the rate of growth in 2008-09 go back to the earlier rate of growth of 5%?
There have been straws in the wind for the perceptive. Some of these indications within the country have been, the narrow growth path of the Indian economy which makes it prone to instabilities, the rising food and energy prices and slow down in growth. Internationally, the western front is not quiet with crisis brewing on many fronts. Like, the sub-prime melt down in the USA leading to a financial crisis in the financial institutions and in the stock markets globally. Losses have run into tens of billions of dollars for the largest financial corporations and the US government put together a bail out package of $180 billion.
According to the latest indications, the US stock market has entered a bear phase. The US economy has slowed down and has possibly entered a recessionary phase with employment dropping since January 2008. This has led to rising uncertainty in the world economy, including a recession in Spain, falling business confidence in Japan, slowdown of industrial production in Thailand and Korea and retail sales decline in Hong Kong and falling corporate profits in China. To complicate matters, prices of petroleum products are rising sharply, global food prices are ruling at high levels and the dollar has declined in relation to the other major currencies. Are these all inter-linked or separate events? This article analyses the causes of this sudden change in the economic scenario in India and the World.
What is alarming is that the policy makers misread the situation so much that they have been caught unaware and have not at all been prepared for it. Recently, in India, the spokesperson of the ministry of finance said that the rate of inflation will continue to be double digit and nothing much can be done about it where as till a few months back it was being confidently predicted that the rate of inflation for 2008-09 would be about 5%. Today, there is an element of throwing up of hands. The public needed some assurance that the policy makers are on top of the situation rather than hearing that nothing can be done.
1. Decoupling debunked.
Policy makers in India had internalized the idea that the Indian economy would be insulated from the major worldwide changes and that they are in control of the economic situation and can continue to coax growth by giving more and more concessions to business so that investments rise. For a while, during the growing financial crisis in the latter part of 2007, a decoupling theory was being propagated by analysts suggesting that the downturn in the US economy would be compensated by the strong growth in China and India. According to these experts (and Indian policy makers), the world economy would be able to weather the gathering storm and India would do well.
Any serious analyst should have realized that for this to happen, for every 1% drop in the rate of growth of the US economy, the rate of growth of these two economies would have to go up by 4 percentage points each which is unlikely to happen given that these economies have been already growing at about the maximum that they can achieve. Further, this rise in the rate of growth has to be a coordinated one which is rather difficult to achieve. Finally, given the strong links of these economies with the US economy a slowdown there was more likely to result in a drop in their own rates of growth rather than a rise and that is already playing itself out. The idea of decoupling is now safely buried under the tattered illusions of the optimists.
2. Slowdown in India: Its Causes
It has also been on the cards that the Indian economy was going to start slowing down after 5 years of strong 8%+ growth since 2003/04. After all it had picked up this growth from a lower base of about 4.7% rate of growth in the three year period 2000/01 to 2002/03. This is a classic pattern of a business cycle – of ups and downs.
Based on the strong rise in the savings and investment rate in the economy in the last 6 years (from 23% to about 35%) the government has argued that the economy has transited to a higher growth path in the first decade of the new century. While this argument is correct in the short run, a classic lesson of a business cycle is that investments continue to rise in the recession phase and as capital stock accumulates, over capacity builds up, resulting in cut back in investments with a lag and then a slump. What can prevent this slump is a strong anti-cyclical public investment programme if initiated well in time but today with the economy following the neo-classical path which requires a strategic retreat of the state, this has neither been initiated nor is it likely.
Further, under the grip of the new policies, government has given concessions to big business so that corporate profits have risen dramatically in the last 6 years and raised disparities markedly (AES, 2007). This major shift in national income in favour of the corporate sector is the underlying cause of the sharp rise in the savings and investment rates. But this kind of rise in inequity in the economy also makes demand narrowly based and, therefore, makes the path of growth rather narrow and also unstable. Growth has been dependent primarily on investments and that too of the corporate sector (risen from 5.5% of GDP in 2001/02 to 12.4% in 2006-07). Any setback to the investment process of this section would immediately lead to a sharp decline in the investment levels and to the reduction in the rate of growth of the economy. Over capacity can be one such trigger and there are indications of this.
Uncertainty in the Indian stock market which is now globalized and takes its cues from the major economies of the world has already taken a toll of investments in the economy. The booming real estate market had grown too fast and was expected to go into a correction phase and there are signs of that. There is over capacity here and the earlier boom in investments in construction is petering out. Infrastructure sector has considerably slowed down. Thus, there are signs of a slow down in investments and build up of overcapacity in some sectors and this is leading to a fall in the rate of growth.
Rising levels of inflation based on a rise in food and energy prices can only result in a worsening of the income distribution in the economy. 93% of the work force is in the unorganized sector and by definition their wages are not inflation indexed so that they lose income share in a phase of rapid rise in the rate of inflation. It is this section which has a narrow consumption basket with heavy dependence on food and energy. Thus, a dramatic rise in the food and energy prices in the last 6 months has affected it the most. Amongst the various consumer price indices, the one for Agricultural labour has risen the most. Thus, demand for goods and services from this segment can only fall.
The organized sector worker is also getting squeezed due to its reduced bargaining power. Trade unions the world over have weakened. Further, the WPI based inflation index is way out of line with the actual inflation faced by this segment of the population. They consume a substantial amount of services and these are not factored into the inflation index (AES, 2006). In the recent phase the prices of many of these services have risen substantially due to greater privatization and the decline of the public sector. One may mention medical expenses, school fees, entertainment, house rental and water as examples of this trend. Thus, inflation indexation of wages, even for the organized sector workers, is inadequate and even this segment will have to cut back demand.
In brief, mass demand is weak and this cannot be compensated for by the rise in demand from the well off sections linked to the corporates who constitute a narrow segment of the population. The data from the NSSO 61st round for 2004-05 presented in the Report of the National Commission for Enterprises in the Unorganized sector (GOI, 2007) shows that 77% of the population consumes less than Rs 20/- per person per day and 96% consumes less than Rs 48/- per person per day. The consumption base is indeed narrow. Even in PPP terms it is not too flattering.
Often incomes are presented in PPP terms to show that the economy is much larger than when measured in dollar terms. But this would make little difference to broadening of demand. Usually, it is argued that in PPP terms the Chinese and the Indian economies are much larger in PPP terms and they can generate a lot of demand for the world economy. Expressing expenditures of the poor in PPP terms (the majority of the population) makes little sense since it is their low wages that are the cause of services (non-traded) being cheap and due to which the value of the rupee turns out to be higher in PPP terms than in $ terms. They themselves consume little of the services they provide since their consumption bundle is heavily weighed in favour of food and energy and other basics which are tradable and have one price (adjusted for taxes and transportation) in any case. It is only for the better off sections that measuring incomes in PPP terms makes a difference and they in any case have high incomes and savings so would not give a big boost to demand.
This picture of very low expenditures by Indians gets modified somewhat when the substantial black economy which mostly escapes the official statistics is taken into account. As shown in Kumar (1999) the black economy was 40% of GDP in 1995-96 and was concentrated in the hands of the top 3% in the incomes ladder. The size of the black economy is likely to have gone up rather than down but let us assume it is unchanged. The implication of all this is that income distribution is even more skewed and the consumption propensity even lower than what official data suggests. Yet, it is this section of the population with substantial black incomes that really constitutes the consuming class in the economy. Since, this is a narrow segment it cannot keep up the growth of the economy on its own, especially when investments begin to decline. We need only recall that the previous high rate of growth of the economy in 1995/96 petered out in two years and fell in 1997-98. The situation today is worse if anything.
3. International Trends
The above mentioned national trends overlie the international trends. Since the Indian economy is substantially globalized, it gets impacted quickly by the global trends.
The world economy has also witnessed rising disparity, whether in China, Russia or the USA. Thus, the base of growth everywhere has narrowed and the world economy as a whole has been open to increasing instability. Since mid 2007 it has been triggered by the financial markets that have grown increasingly complex and are little understood even by experts. That is why the sub prime market collapse and its consequences were not anticipated by the experts. The decline of the dollar has added to the complexity confronting the global financial markets.
The US economy was slowing down and as soon as the sub prime crisis surfaced, the housing market went into a tail spin with foreclosures. A large number of the poor have been most adversely affected. The US economy slowed down rapidly and has been losing employment since January 2008 which is a sign of a slide into a recession (defined as a fall in GDP in two successive quarters). Of course, recession has not been declared but data comes with a lag and we may learn later that the US economy went into a recession in early 2008.
The slow down has also been on the cards due to the strong rise in petroleum and food prices. This has adversely affected the poor the world over, including in the USA and has contributed to the slowing down of the economy. Rise in petroleum prices has also affected several industries, like, the automobile, travel and tourism and air transport. The middle classes in the USA are also feeling the pinch and this is further slowing down demand increasing the chance of a slide into a recession.
4. Dollar No More a Safe Haven
In earlier phases of sharp increases in petroleum prices, in 1973, 1980 and 1990, the petro dollars used to come back to the US economy since dollar was the reserve currency but now that is hardly the case. The dollar has declined against most major currencies of the world so that suddenly it is no more a safe haven. The huge overhang of dollars in the world economy, a remnant of the past export of the US deficits is adding to the problems. Also, several oil exporting countries are now delinked from the dollar so that the oil based surplus funds are looking for alternative investment opportunities.
This means that the US cannot any more export its deficits like in the past and cannot spend its way out so that it is likely to remain in a recessionary/low gropwth phase for much longer than in the past and since it is the largest world economy, this is going to set everyone else also back. The oil surplus countries are suspected to be investing in commodities to take advantage of shortages and this has driven commodity prices higher and led to the inflation that we are witnessing and this further slows down the world economy. Since the financial markets are in turmoil the petroleum surpluses cannot go there either. The avenues for investment are few and, therefore, there is further destabilization of the world economy.
There have been discussions regarding whether the recovery from the slow down will be V shaped or U shaped. That is, whether it will be a quick or a gradual recovery. This is based on the past experience when the above mentioned structural changes had not taken place and so many adverse factors had not come together at the same time. The US economy could spend its way out but since that option is now limited, one needs to discuss whether recovery can take place with the current policy framework and how soon in a far more complex macroeconomic framework.
5. Impact of the Petroleum Economy
OPEC has argued that output has not been falling in the recent phase. Further, it is being supplemented with bio-fuel production. It is estimated that if these fuels had not come into the picture, today crude prices would be higher by $30. It is also known that demand has been rising slowly in the past few years, so, why the sudden spurt in prices of crude oil?
The rise in petroleum prices have resulted in huge surpluses for the oil exporters and the oil companies whose profits have soared. This is simultaneous with the non availability of safe investment channels, like, securities, stocks or currencies. It is believed that the surplus funds have moved into speculation. In NYMEX, after 2002, speculative activity in Oil has increased 5 times more than trading activity. Further, it is suggested that demand is increased by the build up of reserves by those who are betting on rising prices, including some national governments. This is also a kind of speculation.
However, some analysts point to difficulties with production for some producers and especially some Non OPEC oil producers. Output has fallen in Nigeria and Mexico and stagnated in Russia and Venezuela. There are disruptions in production in Venezuela, Iran, Iraq and Nigeria. Most of these are linked to actions and/or threats by USA. Consequently, spare capacity to raise production has fallen. This has also signaled price rise and consequent big increases in profits of petroleum producing companies. One may ask where are these profits being invested? Given the current scenario, what better investment than in oil itself.
Some experts argue that one cannot put the blame on speculation and there is a disequilibrium due to demand not declining even after the massive rise in petroleum prices. In earlier phases of oil shock in 1973, 1980 and 1990, demand had fallen but this time that has not been the case. So, given the inelastic demand, prices had to go up.
However, the definition of speculation used by these experts differs from that used by those arguing that speculation is taking place in the petro product markets. Speculation means buying on the basis of expected prices. If price is expected to rise, inventories may pile up with producers or futures prices reflect in current prices and everyone pays more expecting prices to go up later. Further, one may ask, with petroleum goods prices going up, demand has gone down or stagnated, so, since output has not fallen, why should prices go up under normal conditions of supply and demand? Indeed, the times are not normal and inflationary conditions rule so that for the same good, people pay more with little resistance. It gives the impression of inelastic demand. Prices may indeed fall after a while but in the meanwhile the speculators make their profits.
One interesting aspect of the rapid rise in crude oil prices is that it has not fed into general inflation in most economies, especially in the advanced countries. This is in sharp contrast with the earlier oil price shocks that resulted in high inflation. This is a result of the weakness of labour in the current economic phase. Wages have lagged behind and absorbed the shock. But this has also resulted in the narrowing of the demand base.
In a different vein, it is also worth considering that the price of petro goods is low in a long term historical sense given its rich organic content. In that sense it should be priced far higher than even its current high price. However, no one is using this argument, not even those who suggest that it is not speculation that is governing the current price. Even the environmentalists look at it in terms of energy price and the need to conserve energy, etc.
In brief, terms of trade have shifted from the oil importing to oil exporting countries and this is squeezing demand in the world economy which the oil exporters are not going to be able to compensate for and given the tendency to use the oil surpluses to speculate on commodities, it only accentuates the slow down. There is another terms of trade effect between commodity exporters and importers but that cannot compensate for the primary cause of the changes, the oil price increase. So, the adverse effect on demand is likely. Finally, the dollar is getting weakened by the oil surpluses not coming to the US economy.
6. The Changing Balance in the Food Economy
World food production has continued to rise even if slowly in 2006 and 2007. However, price rise in food items has accelerated in 2007 and 2008. In 1999, grain stocks were at their peak at 580 million tons and by 2007 they have almost halved. This signaled to the speculators that they could speculate successfully.
Less than half of the grain produced in the world is going into direct consumption so that instead of being a source of nutrition, it has become a source of commerce and that is the big problem for the food economy (and the poor). Today, global agribusinesses and speculators dominate the scene and increasingly control the world food economy. Small farmers in the developing world are marginal to the process and they are a major part of the hungry in the world.
This situation has come about over the Nineties because of the logic of free markets propagated by the IMF, the WB and the WTO. They have argued that liberalized free markets will take care of any problems, especially in the food markets, by efficiently allocating resources, etc. Countries were assured that self sufficiency was not required since they could simply import when there was a shortage. This was also the advice given in India and implemented at that time by the current top Indian policy makers.
Free markets were supposed to take care of shortages, etc. Following such advice, Indian food markets were substantially opened up. Consequently, acreage has shifted from less profitable grains to the more profitable commercial crops so that the per capita availability of food has declined in the country (as suggested in Kumar, 1994). Food availability has fallen from 510 grams per day in 1990/91 to 444 grams per day in 2005/06 (GOI, 2008). Since the better off sections are continuing to eat more and better, it is the poor who are losing out and that is why 50% of children and women in India remain malnourished. This has also happened in many other countries in the world. In brief, food security has been dented the world over.
Fertilizer companies, grain trading companies, like, Cargill, seed companies like Monsanto and pesticide companies like Syngenta are making more profits and so are the food processing companies like Nestle and Lever. Retailers, like, Walmart have increased profits from food sales. So, everyone in agri-business is reaping higher profits at the expense of the people.
Amongst other factors, in China, due to urbanization and industrialization, acreage under food has dropped by 6% between 1997 and 2007. In India also, agricultural land is getting diverted to mega projects –power plants, steel plants, highways, airports, SEZs, etc. Further, rising energy prices lead to less use of fertilizers and a fall in productivity. Finally, due to rising prices of oil, bio fuel production has grown. In the US, corn used for ethanol production amounts to 20% of the production, thereby aggravating food shortages.
Low income countries with a larger share of food in the consumption basket are being more strongly affected and will face a more difficult current account position (both because of food and petro products). It is also being suggested that the food exporters are trying to panic the countries into accepting the new GM technology package in the name of increases in productivity and facing the challenge of shortage.
In brief, the energy and the food sectors have got inter linked in a way that is detrimental to the poor people and the poorer countries. The cropping pattern shifts are aggravating the situation further. The rising indirect demand for food from the well off sections has added to the food insecurity faced by the poor. All this in the context of the earlier advice to the developing countries that they need not worry about food security is proving to be detrimental to their national interest. There is an international shift in terms of trade due to the food price rise also but this is relatively small compared to the oil price effect. Finally, food price rise is also leading to a terms of trade shift within the national economies and that is the big effect. It is not only leading to inflation but given the weight of food in the developing countries’ consumption basket, they are leading to a slow down in demand and a down turn nationally.
7. Conclusion
Today, there is growing disparity the world over, rising financial uncertainty, weakening dollar, falling share of labour in GDP and speculation in commodities. This paper has pointed to the interlinkage amongst these problems and how they are together forcing the slow down in the world economy. These trends have resulted in the rising petroleum prices and also through diversion of acreage to bio fuels to rising food prices. This has become a vicious cycle for the poor. Further, since the US economy cannot spend its way out in the changed situation, the prospects for a deep recession are high
The rising disparities cause the tendency for under consumption to aggravate and high rates of surplus generation driving investment are likely to result in over production. This is not just true for India or the USA but for the world economy as a whole. The rise in food and energy prices will affect the BOP of the poorer countries more adversely. The poor everywhere and the poorer countries are likely to bear the brunt of the down turn as is usually the case. There is no decoupling to protect India’s growth and its rising rate of investment is likely to result in excess capacity that would cause the downturn to accelerate. While every situation has some positives, like, India may get more outsourced jobs from companies trying to reduce costs or people may shift to smaller cars or surpluses from commodities may flow to some of the poorer countries, etc., the global macroeconomic effects will overwhelm these micro level changes.
Since the problem is structural and not emanating in any one aspect even though the trigger may have been the financial markets, it can only be resolved by a reform of the structures of the current global economy and the national economies. Since the current orthodoxy in the world economy only understands the situation in one way, it is incapable of providing the needed structural reform whether in the financial markets or for the new global situation of absence of a reserve currency. Consequently, the current slowdown turning into a recession promises to be both deep and long.
In India, Government has suffered from complacency because it was `feeling good’ about the record rate of growth (even though there maybe some doubts as to how good it is AES, 2007). Hence the turn around in the economic scenario has come as a shock. Further, since it swears by the current orthodoxy and has little idea of how to change the present policy framework. It is clear that when the going was good, the government could have done more to ward off the impending problems but it was not willing to consider this and now that the scenario is turning adverse, it is likely to do even less, thereby aggravating the problem.
References:
Alternative Economic Survey. 2006. Over-estimated growth and under-estimated inflation. N Delhi: Daanish Books.
Alternative Economic Survey. 2007. The Macro View. N Delhi: Daanish Books.
Government of India, National Commission for Enterprises in the Unorganized Sector. 2007. Report on Conditions of Work and Promotion of Livelihoods in the Unorganized Sector.
Government of India, Ministry of Finance. 2008. Economic Survey 2007-08.
Kumar, A. 1994. Proposals for a Citizens Union Budget for the Nation for 1994‑95. An Alternative to the Fund‑Bank Dictated Union Budget for 1994‑95. Mimeo. Presented to the Citizens' Committee on February 12, 1994 at Gandhi Peace Foundation, New Delhi. Prepared for the Preparatory Committee for Alternative Economic Policies.
Kumar, A. 1999. The Black Economy in India. N Delhi: Penguin (India).