This is the first of two parts. See part 2
India emerged relatively unscathed from the financial crisis of 2007-08 to post healthy GDP growth of 7.4% in the 2009-10 fiscal year, even with a poor rainy season during this period. (The Indian financial year is from April 1 to March 31.) First half GDP growth this year has been reported at 8.9 percent over the same period in the previous year. (Statistics released by Central Statistics Office (pdf) (CSO), Ministry of Statistics and Programme Implementation.) The country has attracted large amounts of foreign investment in the form of FDI as well as portfolio investments this year.
Given the continuing economic problems in Europe and the United States, India along with many other emerging markets has seen an increased influx of foreign capital. Capital requirements for Indian industry remain high given the rapid expansion of the economy, which means FDI investments are easily absorbed. Portfolio investment in India this year has broken all previous records resulting in a steep rise in the equity markets. This has increased the chances of bubble formation. Between April 1, 2009, and November 8, 2010, the BSE Sensex zoomed from 9,901 points to an all-time closing high of 21,004 points. That index has been hovering around the 20,000 mark ever since.
Since India is geographically large, and socially and politically complex, any economic analysis cannot ignore the role these factors play in the makeup and management of the Indian economy. India has a huge number of poor people with over 400 million living in poverty. To put this in perspective in absolute terms, India has one-third of the world’s poor. Hence, government economic policy many times is skewed heavily toward poverty alleviation and subsidization of essential goods.
I hope that the following analysis gives the reader a broader picture about India than just a narrow macroeconomic description and that the reader comes away with a better sense about the country and its complexities, as well as about the rapid changes it is undergoing. Ultimately this is only a short article, and hardly exhaustive, but one that I hope will increase curiosity while broadening understanding.
I. GDP TRENDS AND THE COMPOSITION OF GDP
India has shown not only strong but resilient economic growth for the past 5 years. Growth has been strong but with some negative effects in the period of greatest global financial turmoil in 2008-09 and 2009-10. The international financial crisis that broke in late 2007 devastated many western economies. The Indian economy suffered a slowdown but growth continued to be positive in this period.
TABLE 1 – GDP at Constant Prices and Year-on-Year % Change
(Click charts to expand)
Source: Reserve Bank of India
FIGURE 1 – GDP from 2005-06 to 2009-10
At the time of independence in 1947, India was largely an agrarian society with pockets of industrial activity clustered mostly around the cities of Mumbai (Bombay) and Kolkata (Calcutta). Not only was most of the Indian population rural and involved in agriculture, but agriculture was by far the single largest component of GDP. Calculated from data available from the period 1951-52 to the present, Table 2 shows the tectonic shifts that have taken place in the Indian economy and in India society. Agriculture as a component of GDP has shrunk from 55% in 1951-52 to 14.6% in the present. On the other hand industry and services have almost doubled in their proportionate contribution to Indian GDP.
This is reflected in the massive urbanization that has taken place in the Indian economy, so much so, that while in 1901 only 1 in 10 Indians was an urban dweller, today 1 in 4 Indians live in cities. It is only to be expected that as India integrates further into the global economy, the importance of industry and services will increase. The urbanization of India will also most probably continue apace presenting policymakers and business leaders with new problems and opportunities.
TABLE 2 – Components of GDP (%)
Note: Data for Industry includes Construction.
The overall outlook for GDP growth in India will be discussed at the end of this article.
Agriculture employs 52% of the country’s workforce while only contributing to 17.1% of the GDP; a fact that is reflected in the massive numbers of people living in poverty. The agriculture sector has made tremendous advances since the Green Revolution of the 1960s during which new high yielding seeds were introduced along with widespread irrigation and fertilizer use. In international comparisons, however, Indian agricultural yields lag the highest yields found elsewhere in the world. The agricultural sector has been declining proportionate to GDP but still is of great socio-economic importance. With over half of the country’s population tied to agriculture for a livelihood, the rainy season, which is the lifeblood of Indian agriculture, has a huge effect on poverty and as a consequence economic policy.
Low agricultural productivity is the one of the greatest challenges facing Indian agriculture. If India is to evolve into a middle income country with a broad-based middle class, then rural reform, greater agricultural productivity, and sufficient employment growth in the manufacturing and services sectors are all necessary conditions.
Agricultural production was down in 2009 because of a poor rainy season. Overall food grain production in 2009-10 was 7 percent lower than the previous year, and oilseed production was off by 5%. (Source: Economic Outlook 2010 by Economic Advisory Council to the Prime Minister) Overall the agriculture sector managed to register 0.2% growth because of resilience in horticulture, animal husbandry, and fisheries.
One major factor affecting the Indian monsoon is the El Nino Pacific Ocean current off the west coast of South America. This periodically active current is very closely correlated with droughts in South and Southeast Asia. Every year that summer rainfall has failed in India has been a year when the El Nino has been active. Conversely, every El Nino year has not been a drought year in India. In any case, no El Nino is forecast for 2011, so the monsoon outlook looks good. 2010 has not been an El Nino year either and the monsoon this year was good.
The better rainfall this year has resulted in far higher agricultural growth. The CSO reports that the country’s farm sector grew by 2.5% and 4.4% in the first two quarters of this year (April 1 through September 30, 2010). With the good rainy season this year and the expectation of good rains next year too, the outlook for Indian agriculture in 2011 is good. The sector should grow by between 6.5% and 7.5% over 2009-10.
Industry accounts for about 28% of Indian GDP when construction is included. The Indian Index of Industrial Production (IIP) does not include construction even though internationally it is. Because of this, IIP data wherever cited in this article, will not include construction activity.
The Indian manufacturing base is highly diversified encompassing mining, power generation, chemicals, petrochemicals, metals, transportation equipment, machinery & equipment, paper, and textiles. Manufacturing makes up about 79% of total industrial output, while mining and electricity account for about 10% each.
India has become an important sourcing point for automotive components for the European and North American markets. The last decade-and-a-half has seen the influx of some of the world’s largest automotive manufacturers into the country including Ford (F), Mercedes Benz, Fiat (FIATY.PK), Toyota (TM), Hyundai (HYMLF.PK) Nissan (NSANY.PK), Honda (HMC), Audi, and Skoda, in addition to Suzuki (SZKMF.PK), which entered the Indian market through a joint venture with the Indian government in 1981. Several large motorcycle companies have also established a large presence in India including Honda, Yamaha (YAMHF.PK), Kawasaki, and Suzuki. India is the 2nd largest two-wheeler market, the 4th largest commercial vehicle market, and the 11th largest passenger car market in the world. Transportation equipment and parts is the single fastest growing manufacturing segment with 29% growth in output during the period April-October 2010 over the same period in 2009.
Transport equipment & parts isn’t the only fast-growing manufacturing sector. Other product categories that have also grown fast year-on-year are metal products and parts except machinery; rubber, plastic, petroleum and coal products; and cotton textiles.
Even as the industrial sector has been growing over the long-term there is some cause for concern. The industrial sector has actually shrunk from one month to the next a few times this year to the extent that industrial output has fallen since it peaked in March 2010. Table 3 below shows the Index of Industrial Production data for the period April 2009 through October 2010. The General IIP is the weighted average of mining, manufacturing, and electricity. IIP itself is a number that represents a monthly measure of industrial production and is tied to the production level of a previous period as the base. In this case the base year is 2004-05 and the prices are based on the Wholesale Price Index.
TABLE 3 - Index of Industrial Production (Sector-wise & General IIP Based on Wholesale Price Index 2004-05)
FIGURE 2 – General Index of Industrial Production Jan ’10 – Oct ‘10
As is apparent from the table the General IIP for the month of October ’10 is actually not only down from its peak in March ‘10, but lower than its levels in December ’09, and January ’10 and equal to February ‘10. The Indian government, when it reports the monthly IIP figures, compares them to the same month of the previous year. Using this method, the IIP is indeed up strongly. However, when doing a comparison from month-to-month, IIP growth has been muted this year and the index is actually down from the end of last year.
TABLE 4 – Exports (US$) April-November 2010
Much of the decline in industrial production has been blamed on the strengthening of the Indian Rupee and declining exports. The export data for the year to date doesn’t support this theory, however. The data in Table 4 shows exports from April-November 2010 haven’t fallen.
Inflation, on the other hand has been running high through the first half of 2010, forcing the Indian central bank, The Reserve Bank of India (RBI), to increase rates and make real interest rates positive. Since the country had emerged from the crises of 2007 and 2008 in good shape with healthy growth and general optimism, this was not a terribly ill-timed policy.
It is possible that with rising interest rates consumption and capital investment have moderated. The likelihood is that this trend towards flatter industrial growth continues in 2011 given the RBI’s interest in keeping inflation low through interest rate and monetary control measures. The moderation in industrial growth could end up holding back overall GDP growth if this trend continues next year. The issues of finance and monetary policy will be discussed in far greater detail later in this article.
Domestic consumption and economic recovery in Europe and North America will play a huge part in industrial growth in India. The wealthier economies to a large extent support the Indian services sector. The thriving services sector in turn fuels demand for the goods made by Indian industry. The financial crisis caused a slowdown of the Indian economy. A repeat of 2008-2009 could derail the still fragile recovery in the U.S. harming the Indian economy. On the other hand continued recovery in the U.S. and no serious shocks from Europe would ensure very high industrial growth next year.
Industrial performance in India in 2011 will depend more on external factors than on domestic circumstances. Europe is going through a difficult phase and the odds are very high that a real crisis may develop with global repercussions. The combination of higher domestic interest rates and the likelihood of a European financial crisis will probably result in moderate industrial growth. Industrial growth in 2011 will likely be between 6% and 7% with significant downside risks.
While industry still makes up a sizeable proportion of Indian GDP, it is the services sector that is playing an increasingly important role in the Indian economy. Services, which made up only 29% of GDP in 1951-52, grew to 57% of GDP by 2009-10. In India, the government classifies the following in the services sector: Construction; Trade, Hotels, Transport, & Communications (THTC); Finance, Insurance, Real Estate, & Business Services (FIRBS); and Community, Social & Personal Services (CSPS).
For the purposes of this article, construction will be included in the data for industry and not in services as is the international norm.
TABLE 5 – Segment-wise Breakup of the Indian Services Sector (%)
The services sector has grown rapidly over the past six decades to almost 60% of GDP. A variety of factors have contributed to this growth: economic and financial reforms, privatization, trade reform, Information Technology Enabled Services (ITES), and an overall opening up of Indian society and economy to the world. The services sector has also absorbed the huge numbers of young, fresh graduates from institutes of higher education ensuring the growth of the middle class. The export of ITES services, which includes software and Business Process Outsourcing (BPO) from India, has also helped to ensure consistent economic growth as the demand for these services as a cost saving measure in the west remains high.
The services industry in India is well diversified due to which overall growth in the sector has been resilient even through economic troughs. From tourism, airlines and hotels, to finance, insurance and banking the sector has shown very strong growth for decades so that it now occupies a dominant position in the Indian economy.
The outlook for services in 2011 is good to the extent that the Indian financial system is nowhere nearly as exposed to the financial instruments or the loose lending that many western banks were involved in. The risks that remain are mostly to do with instability in mainly western financial markets, and the huge amounts of portfolio capital invested in India.
One segment of the services sector is the ITES industry which is the arguably one of the most internationally recognized industries in India. It is also one of the most vulnerable to the ups and downs of the world economy and to the vagaries of politics. Growth in this sector has slowed down since the financial crisis. ITES exports fell from $ 44.5 billion in 2008-09 to $ 41.6 billion in 2009-10. Growth this year is expected to only remain flat at 2009-10 levels. ITES makes up about 5% of Indian GDP but its effect on perception and business confidence is disproportionately large. If Information Technology (IT) companies report less-than-stellar earnings, business confidence and the stock market falls at least for a short while. The good news for Indian IT companies is that the U.S. economy is showing real signs of a modest recovery and the fact that American companies have trillions of dollars in spare unspent cash.
With high economic growth services will do well, benefitting from business confidence and feeding the growing economy in turn. The 2011 forecast for services comes with the same caveats as the industrial outlook. The probability of a fresh financial crisis remains high in 2011, which would impact not only Indian software exports but hinder funds inflows that have until now fueled the growth of the sector. Absent any major external shocks like a financial crisis in Europe, the United States, or anywhere else, the service sector should grow by about 6-8% in 2011.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.