Will inflation affect growth? Business Standard June 13, 2008

A question that keeps popping up time and again is whether or not growth will be affected this year on account of inflation. At present, we are revelling in a growth rate of over 9 per cent in the last three years, though there is a fear that the party may be spoiled. Inflation is expected to be in the 8 per cent range, which will be unusual because it has been a very long time since we have had such an inflation rate — the last time in 1995-96. The recent hike in fuel prices announced by the government would up inflation by at least 1.2 per cent (0.6 per cent directly and 0.6 indirectly) and hence negate the possible softening of prices in the food segment if the kharif harvest is good. The apprehension about low GDP growth is real.
The economic rationale for such an expectation is compelling. High inflation lowers spending power of people and hence affects the demand cycle. Industrial growth would be affected by a combination of two factors surrounding interest rates. Interest rates will tend to move up as the RBI tries to use monetary policy measures to preempt demand pull triggers. This will increase the cost of funds and hamper investment to begin with, which will have a bearing on industrial growth directly. Simultaneously, consumer credit will be affected in the mortgage segment thus, leading to lower demand for all related products. The automobile industry is also heavily dependent on the overall interest rate structure in the country, although it is still debatable about whether demand is sensitive to such interest rate changes where ‘snob' value dominates. There is, hence, reason to believe that inflation would have an adverse impact on GDP growth.
However, past data have a different story to narrate. When inflation crossed 8 per cent last in FY96, we were already on an upward trajectory, and GDP growth continued to accelerate over five successive years. The next ‘high' rate of inflation was in FY01, at 7.2 per cent, when GDP growth was down at 4.4 per cent. But this was on account of decline in agriculture and low growth in the services sector, rather than an industrial slowdown. Manufacturing growth per se was buoyant in that year. In fact, curiously, high increases in prices in the manufacturing sector have always been associated with a higher growth in this sector. Conventional economic theory says that higher prices induce industry to produce more which has been the case here.
Over time, another buffer which has been built is the services sector. The services sector accounts for 55 per cent of India's GDP. Growth in this sector has, in the last five years, averaged 10 per cent. Growth in services sector is quite divorced from the prevailing inflation rate as it includes two critical components. The first is the government sector which is seldom influenced by inflation and the other is the unorganised sector which lends an upward statistical bias in such situations. The unorganised sector accounts for around 40 per cent of services.
The construction segment has averaged a growth rate of 13.3 per cent in the last five years. This growth has been driven by both the interest in infrastructure as well as a housing boom. The former is an ongoing process and will not be impeded by higher inflation, while the latter could be affected. Here, two things come into play: The expectations of real estate prices in future as well as the structure of interest rates. Interest costs can come in the way of potential borrowers at the retail level. But, will interest rates rise?
In the past 15 years or so, interest rates have been linked more to a trend being pursued by the RBI, than related to an inflationary phenomenon. From 1994 to 2006, the PLRs have shown a declining trend, while rates have gone up in the last two years despite average inflation of 5.1 per cent. Further, with interest rates being offered today providing an alternative route of a floating structure, there is reason to believe that the interest rate may not be the clinching factor for deferring a purchase of a dwelling. Also, if expectations are that interest rates would move up further, then it would make sense to get into these deals today.
Therefore, with around 62 per cent of GDP coming from the extended services sector, which may not be influenced by higher interest rates, even if they do increase, it is the balance 38 per cent which can be affected by inflation. Industry, which accounts for around 20 per cent of GDP has been positively correlated with prices and may be resilient to inflation. Agricultural growth would be independent of inflation and more dependent on the monsoons.
Under these circumstances, an attempt may be made to hazard a guess on GDP growth for the year. The services sector may be assumed to remain on the trend path of 10 per cent, which will bring in a growth rate of 6.2 per cent in GDP. Industry, with a weight of 20 per cent, could be assumed to grow at a conservative rate of say 8 per cent, which would bring in another 1.6 per cent points growth in GDP. We also have an ambitious exports target where manufacturing would be the leading sector. Growth of 4.5 per cent last year may not be maintained as this sector has tended to display a cyclical pattern over the last two decades, and a more conservative rate of 2 per cent can be assumed on the higher base registered last year. This will mean an increase of 0.4 per cent in GDP. Adding the three components, growth would be at around 8.2 per cent, which will be lower than the 9 per cent registered last year.
Therefore, overall growth would be between 8 per cent to 8.5 per cent this year, and that would not be really a bad number.