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War-induced recession?

April 07, 2003

The US-Iraq war will have an adverse impact on the Indian economy in the short-term, but that  does not mean any major long-run upheaval.

While the second and third quarters of 2002-03 were devoted to assessing the implications of failed monsoons for the economy, the discussions on the Budget and the Iraq war have dominated the last quarter.

At this point, no meaningful assessment of the prospects for the Indian economy in the coming few months can be made without reference to the impact of the war.

In this article, we first review the performance of the economy over the last year and then speculate on its short-term prospects.

Review of 2002-03

Despite being one of the most rainfall-deficient years in the past, 2002-03 witnessed a pick up in industrial activity, booming exports and moderate inflation.

Industry: A 6.9 per cent growth in the manufacturing IIP pushed up the overall industrial growth in January to 6.4 per cent.

This, together with an upward revision of IIP growth for the months October and December, peg the industrial growth during April-January at 5.5 per cent.

All industrial sectors, viz. manufacturing, mining and electricity, have significantly improved their performance in FY03. The chart below compares the growth in industrial sectors during April-January 2003 over the corresponding period last year.

Over the last few months, the recovery in  the manufacturing sector had been quite narrow with five to six sectors accounting for the entire growth. Manufacturing data for the month of January 2003, however, indicates that the recovery is now getting broad-based.

In January, the sectors contributing to growth had a weight of 81 per cent - much higher than the average of around 50 per cent in the last 10 months. In some buoyant sectors, the pick-up in growth in January was due to the low base last year, like wool and silk, jute, leather and machinery and equipment.

At the aggregate level, however, a 6.9 per cent growth in January 2003, over four per cent last year is not due to the low base but rather the resilience and buoyancy in some sectors like textile products, beverages, rubber and petroleum, basic metals and transport equipment.

The capital goods sector has done well for quite some time now. During April-January it registered a growth of 10.6 per cent. We have been arguing that this does not signal investment revival as the growth trigger for this sector has been transport equipment, and not machinery and equipment.

The data on machinery and equipment for November-January shows that the growth in this segment has moved from negative to positive territory.

Trade: The upward march of exports was halted in the month of January when export growth shrank to 9.2 from 34 per cent in the preceding month. Slowdown in consumer spending led by war fears in the US and other Western economies could be the primary reason for this.

Oil import growth (y-o-y) was robust in January driven by efforts to build a buffer against a price spike in the event of war. Non-oil imports remained high reflecting continuing domestic economic recovery. The current account continues to be in surplus.

Inflation: The overall inflation rate based on the WPI for all commodities rose to a fiscal year high of 4.9 per cent in the month of February. It climbed up to 5.7 per cent by the middle of March. All commodity groups contributed to this overall firming up of prices.

Rising inflation in the manufacturing sector was mainly on account of buoyancy in domestic demand due to industrial recovery and indirect impact of consistently rising fuel prices.

In primary articles, relatively high inflation was witnessed in the crops adversely affected by drought.

Till the last month, rice, which has a higher weight and enough buffer stocks, remained insulated from inflationary pressures. February saw a firming up of inflation in rice to 3.4 per cent from 2.6 per cent last month.

Prospects for 2003-04

The dominant perception in the media is that the war has gone relatively badly for the US-led coalition, which means that it will last longer and cost more than anticipated earlier. The question is: is this possibility likely to upset the economic applecart for both India and the rest of the world?

Before addressing this question, it must be borne in mind that if the war had not happened, the Indian economy was looking set to maintain the momentum that had gathered over the last few months.

Most analysts expected to see the industrial buoyancy to continue and even widen across sectors, even while low inflation prevailed. Persistent higher oil prices resulting from a prolonged war will certainly weaken these impulses.

Inflation will increase, industrial production will decelerate and corporate bottomlines will be hit. In the face of rising prices, the Reserve Bank of India will be faced with a familiar dilemma; Should it pursue inflation control, allowing interest rates to rise, or should it gamble on its current position on interest rates to support the industrial recovery and risk fuelling inflation?

From the fiscal perspective, higher inflation may not affect revenues very much, because the revenue base is nominal GDP.

A slight slowdown in production accompanied by a slight increase in prices can be accommodated. However, expenditure is relatively sensitive to inflation and this could send deficit control efforts off-course.

On the external front, higher oil prices will depress the global economy, so Indian exports will suffer. The Gulf region accounts for about 11 per cent of India's exports and about $ 3.5 billion worth of remittances a year.

These flows could be adversely affected in the short term. With higher outgoings for oil imports, a worsening of the current account deficit is clearly on the cards.

Focusing on the rupee, the war should increase the tendency to depreciate. The tendency will be further reinforced by the upward pressure on the US dollar likely this year, not so much because of a war spending (although this will contribute if it becomes very large) but because of the widening fiscal deficit provoked by significant tax cuts.

Currently, however, an increase in the flow of funds into emerging markets is bringing more FII money into India and is helping to prop up the rupee.

But, all this is predicated on a long and messy war, or if not war, prolonged instability in the major oil-producing region.

It is important to emphasise that, despite the perception that the war plans are going awry for the coalition, oil markets are yet to react very sharply.

This suggests that informed oil traders had already discounted the prospect of the war scenario that is unfolding now. In other words, the state of conflict as it exists today is no reason to expect any drastic consequences.

There will clearly be adverse short-term impacts, but no major long-run upheaval. Perceptions about the coalition's ability to bring and maintain post-war stability could change dramatically and trigger a sharp increase in oil prices.

This is something that needs to be kept a watch on, but until it starts happening, a reasonable assessment is that, while the war may be significant in many ways and for many reasons, its economic consequences are not yet a cause for great concern.

Opportunities

  • A pickup in industry, primarily driven by construction and exports, and a healthy growth of services.
  • Low inflation despite poor agriculture.
  • A persistent soft interest rate regime.
  • Buoyant tax revenues due to pickup in industrial activity.
  • Food and foreign exchange buffers providing protection against weather and external shocks.

Threats

  • Apart from housing, investment demand has shown no signs of a pick-up.
  • The Iraq war poses a significant threat to industrial recovery.
  • Higher oil prices  will push up inflation and interest rates and slow industrial growth.
  • Despite healthy tax revenues, the fiscal situation has been uncomfortable. Revenues have been short of budgetary targets. The divestment programme has been lacklustre.


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