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January 17, 2008

Indian Economy

Known Unknowns

By Nitin Desai


January is a month when, with the change of the year, journalists and columnists suffer from an uncontrollable urge to make forecasts of what the next year has in store.  There is of course no reason for privileging the twelve months that begin with January.  But bad habits die hard and perhaps it is appropriate that we indulge in such speculation in a month named after a god with two faces, one looking backward and the other forward!


The factors that will influence the economy in the months to come are reasonably well known.  But the direction in which these factors will move is uncertain.  Hence this assessment of the near future is a description of what could be called the “known unknowns”.


The first, and perhaps the most important, “known” for judging economic prospects is the slow down in the US economy with the fourth quarter 2007 GDP growth rate there coming down to below 2.0 per cent.  US economic growth is expected to be sluggish in 2008 and so too in the Euro-zone and Japan.  In fact most analysts are looking to continued high growth in China and India to maintain global GDP growth at 4 per cent or thereabouts.


The “unknown” is whether the slow down in the US will lead into a recession (defined as a fall in GDP for two successive quarters).  At the beginning of 2007 Greenspan had put the chances of a recession in the US at one-third.  More recent estimates by informed observers have raised this probability to one-half or more because of the prevalence of  two conditions that typically precede a recession, high oil prices and increased short term rates,  the major slow down in the US housing market and the possible impact of falling house prices on spending.  The recession could also be longer than recent ones. 


If this “unknown” comes to pass then the impact on global growth will be quite severe and our ambitions for a 9-10 per cent growth will be endangered.  The next budget could take preemptive action to boost domestic demand.  But will that help if the export production and production for domestic demand are not readily substitutable? Boosting domestic demand may also be complicated by the growing reluctance of banks to lend to small borrowers because of the difficulties recently encountered in  effecting recoveries.


The higher probability assessments of a US recession do not assume any worsening of the credit crunch or a further increase in oil prices.  In the case of credit the subprime crisis is a “known”.  It has already led to a credit crunch as OECD financial institutions discover how much their asset base has been eroded by subprime defaults and become particularly risk-averse in deploying their assets.  The “unknown” is whether defaults will move beyond subprime mortgages to other areas.  There is some news of a rise in credit card debt and consumer debt default. The big crunch could come if this spreads to business defaults induced perhaps by a recession.  If that happens the flows of FDI and FII finance will clearly be affected. 


Oil prices are already at $ 100 plus a barrel.  That is a “known”.  What is “unknown” is the prospects for the year ahead.  It could be argued that a slow-down in growth in the OECD countries will put a downward pressure on oil prices and this is an “unknown” which would positive for global growth and India.  There are indications that gasoline prices going over $ 3 per gallon in the US has had some impact on demand and most forecasts of crude oil prices in 2008 suggest a decline from present peaks.  But to this “known unknown” one must add an “unknown unknown” – a political flare-up in the Middle East in any one of the many tinder boxes lying around there. 


Similar arguments could be advanced for other commodity prices, including food prices.  In this case too, the “known” is the high level of current prices and the “unknown” is how this will play out in a potentially recessionary situation.   


What about the “known unknowns” closer to home?  Right now there is some concern about the appreciation of the rupee, which is a “known”.  Much of this appreciation is because of the large inflows of foreign investment.  If earnings growth in corporate India continues at 25-30 per cent, as many analysts expect, then inflows of portfolio investment may even increase. Or will an expanding global credit crisis lead to a sharp cut back in inflows and may be even a downward pressure on the rupee because of a current account deficit worsened by slow OECD growth? This “unknown” is further complicated by the potential clout of exporters in labour-intensive sectors lobbying for a competitive exchange rate in a pre-election year.


This brings us to the big “known unknown” that will impact on the economy – how will the Congress party’s political prospects shape up and how will its relationships with its coalition allies and supporters affect economic policies in the run-up to the 2009 election?  The “known” here is the disastrous performance of the Congress in the Gujarat and Himachal elections.  The “unknown” is how it will fare in the State elections due this year. Beginning with Meghalaya next month, Nagaland, Tripura, Mizoram, Karnataka, Jammu and Kashmir, Rajasthan, Chhattisgarh, Madhya Pradesh and Delhi will go to the polls over the next few months.  If the Congress fails to capitalize on anti-incumbency sentiment and make inroads in BJP ruled states then reforms will be put on a back burner and new populist initiatives can be expected as the ruling party tries to bolster its position for the impending general election.  But if it does win in Madhya Pradesh and Rajasthan it may be persuaded to fight on an effective governance platform. But the chances of this happening look rather low.


Politics in 2008 will be dominated by the positioning of parties for the general election.  That is “known”.  The big question is whether this political compulsion will make it difficult for the government to take the steps required if the “unknowns” at the international level move in an adverse direction. The answer unfortunately is yes.

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