Putting the Brakes on India's Growth

India continues on its high-growth trajectory, with GDP expanding at or about expected rates. However, the economic data have weakened in recent months, causing worry for many people. This of course reflects the impact of the sharp appreciation of the rupee during 2007. The rupee has stabilized now, but other factors like high prices and rising commodities are starting to cause worry. It was widely agreed that RBI's policies for the last 2 years was based on the judgment that the Indian economy was overheating, as demonstrated by the 9% growth rate and higher inflation. However, the expected moderation doesn't appear to be too severe as the economy appears to be cooling, albeit from other concerns.

Sharp appreciation in the rupee in the first half of 2007 resulted in a significant decline in the growth rate of exports and the stronger rupee also contributed to the slowdown in industrial production during the second half of 2007. The currency has since stabilized, as the central bank has returned to its previous position of a tightly managed gradual appreciation. However, the overall economic situation has started to have its impact on what looked like India's once unstoppable economic growth.

However, even as growth slows, risks to inflation are still significant as a result of elevated global oil prices and, increasingly, rising global food prices. Its interesting to see that the central bank hasn't yet responded to the prospect of growth slowing to a level that might not be acceptable to below-trend level.

GDP growth reached a peak of 9.8% during 2006 thanks to strong growth momentum in services and industry. The services sector has been growing at a persistently high rate since the late 1990s, and the industrial sector has accelerated sharply from a relatively sluggish phase during 2003 and continued to gain momentum until 2006. However, after peaking in early part of 2007, industrial production decelerated steadily, which clearly seems to have translated into lower aggregate growth.

The difference between growth rates of GDP and industrial production is the result of continued momentum in the services sector, which has not displayed significant sensitivity to either rising interest rates or an appreciating currency. Changes in the macroeconomic environment have undoubtedly affected certain activities such as currency appreciation and growth slowdown in the services sector. However, the aggregate continues to grow at rates that reflect both expanding domestic demand and highly competitive exports. Agriculture also contributed significantly in 2007, which currently bodes well for food prices.

Rising Inflation Could Make It Difficult For The Reserve Bank To Cut Interest Rates - The economy's vulnerability has been highlighted as there has been a sudden change in food supply due to rising prices. Call from the CPI and Left to withdraw support to the govt (Again!!) has made many people sit up and realize the problem has gotten bigger than we would have liked it to. However, the combination of slowing growth and persistent inflation threats from the supply side, for both food and oil, poses a significant challenge to monetary policy.

The Rupee Will Continue To Appreciate, but gradually. The most significant development on the exchange rate front was the large and rapid appreciation of the rupee during the second quarter of 2007. This was followed by a change in the RBI's policy. Previously, the RBI accumulated the balance of payments surplus as foreign exchange reserves. But the inflationary consequences of persistent reserve accumulation in the face of a dramatic increase in the balance of payments surplus motivated the change in policy stance. A sharp surge in capital inflows early in the first half of 2007 made continuous RBI intervention unsustainable. As a result, the rupee rose at an uncontrolled pace in the second quarter of 2007. However, in the third quarter of 2007, the central bank seems to have reverted to its stance of controlled appreciation.

The Biggest Threats To India's GDP Are At Home. India may be the world's largest democracy. But it also comes with a costly tag of not being able to move quickly on taking decisions unless a consensus has been reached among all of India's political parties. This does put India at a big disadvantage as it almost always causes one to miss the bus and act only after the fact instead of being able to take decisions at the right time. Because of this it should be pointed out that domestic factors are the main cause of this deceleration. Because the recent growth has been driven by domestic factors, India is relatively insulated from a mild U.S. and global slowdown.

India's growth and GDP is expected to fall to 7.5%-7.8% in 2008 from the 8.7% growth it enjoyed in 2007.