Overheating and all that

Since India's overheating (or not) seems to be the hot topic nowadays, I figured I may as well add to the clutter of comments on the topic. My comments on the now-famous Economist article -

The Economist's main message seems to read - "India's current pace of growth cannot be sustained, let alone increased, without further reform". The issue of - "what is a sustainable rate of growth for India's economy, in (a) status quo and (b) with further reform"- is so complex, nuanced and subjective that its hard for us non-economists (and possibly many economists) to have a definitive answer on the subject.

Without getting into the sustainable-rate-of-growth question, some of the more objective points raised in the article are valid and reflect some of my concerns as well. The points being made are two-fold, one with immediate and the other with longer term implications -

(1) The economy seems to be overheating, indicating that current levels of growth may not be sustained. The main signs of overheating mentioned are rising inflation, high(er than optimal) capacity utilization, steep credit growth and high current account deficit.

(2) Without substantial improvements to infrastructure - both hard (roads, power, irrigation, water supply) and soft (education, health) - and labour-reforms, India's long-term growth can be seriously hampered. While 'overheating' is a subjective term, I agree on rising inflation being a serious concern. The recent RBI monetary review focused almost exclusively on inflation, and there are no easy answers to containing inflation without slowing growth. In a democracy, inflation can even bring down governments (as it happened a few years back when onion prices rose sharply). High inflation has been mainly driven by rising food prices (over 9% in primary articles), which have to some extent been affected by domestic food production (either lower in absolute terms or slower growth across rice/wheat/pulses compared to the previous year). Among non-food/non-agri products, only cement has seen dramatic inflation (17%). In addition to RBI's monetary policy, the government is also taking sector-specific steps (e.g. allowing wheat imports) to reduce inflation and has some headroom to further reduce petroleum prices. While inflation is a problem, it's too early to definitively judge that this cannot be managed without seriously slowing growth. To put it in perspective, we're into year-5 of 8% growth and we are seeing inflationary strains only over the last few months. Asset inflation (ie. real estate) is a different story, though this affects the (non-voting) middle-class more than the (voting) poor. This becomes a separate discussion on real estate.

While the other points on 'overheating' are directionally correct, I dont see them as speedbreakers. Given Indian companies' propensity to be stingy in how they spend capital (high RoEs), utilization levels do tend to be high until new capacity comes online with a lag. Apart from cement, there havent been steep price rises due to demand-supply mismatch. Steep credit growth has to be viewed in the context of a low base (mortgage:GDP is still under 6%) and the issue is more around quality (once again, real estate) rather than quantity of credit. Current account deficit is largely due to oil-imports, and non-oil import growth has actually slowed in 2006 (grew at a measly 11.5% in H1, FY07).

The second point on infrastructure, education, labour-reform etc is spot-on and something that a lot others have emphasized. In the long-run, these will decide India's sustainable rate of growth. While we've seen early signs of physical infrastructure being improved, we havent done anything to address the other areas. Being a democracy, areas like labour-reform would be really tough to push through and may never happen. Demographics can only ensure that the working age population grows faster than the total population. Whether this army of workers is productively engaged depends on opportunity creation (without infrastructure & some labour flexibility, we wont have enough manufacturing jobs) and skill-building (ie. education).

I think the Economist is right to the extent that India's not earned the right to grow at 9-10% just yet, and has a lot of reform/infra-building left before getting there. While we hope for this growth, I dont think anyone is taking this for granted. However, it seems too harsh pronounce 8% growth unsustainable based on one quarter of high inflation.