Why industrial growth slumped?
(The views expressed in this column are the author’s own and do not represent those of Reuters)
The fall in the rate of growth of industrial production in two successive months was a bit too sharp and expectedly evoked concern both from the Ministry of Finance and the RBI. What is worse, this fall in not a random oscillation but a persistent trend.
After the setback caused by the global financial crisis, industrial growth had bounced back since August 2009. For 10 months since then, the rate of growth averaged 13 percent which suddenly collapsed in August and September this year. There are reasons for this unusual behavior of industry.
The high growth until July this year was not so much because production had increased but simply because growth in the previous year had shrunk. The low base of 2009 yielded a high growth in 2010 with or even without increase in production.
Industrial production peaked in March 2010 with the index crossing 350 (1993-94 = 100), and thereafter the industrial production declined. Production in August, for instance, was 8.8 percent less than in March. It is the fall in production since March, not just the drop in growth that should be the cause of concern.
There are three reasons for this trend. First, due to high food inflation there has been some transfer of consumer expenditure from industrial to agricultural products. Obviously, no consumer would like to economize on food and, since food inflation has been nearly three to four times the inflation in manufactured products, the extent of diversion of consumer expenditure from industrial goods to food would have been substantial.
Second, since March 2010 there had been a fall in exports which now are a significant part of industrial production. From a peak of $20 billion in March, exports dropped to $ 16 billion in August, though there was some improvement in September. For the industry as a whole, about 12 per cent of the production finds market abroad. Hence the fall in exports would have caused industrial production to be cut by 2.5 per cent.
Third, it appears that the persistent increase in interest rate by the RBI impinged on investment in inventories and capacity expansion. An increase in interest rate makes inventory holding costly and the consequent reduction slices off demand and forces industry to adjust production accordingly.
It is also apparent that investment in capital goods in new units and expansion of capacities in existing units has been affected by the increase in interest rate. This is possibly why the capital goods production which accounts for 9 percent of the total industrial production declined 17 percent and would have dragged the overall production index.
It is critical that industry grows at over 10 percent per year if GDP has to maintain 9 percent growth. Food inflation has come down though not sufficiently and food prices may remain high for some time. Therefore, it is essential to ensure that exports increase and interest rate is reversed.