The Hindu Business Line : Negative growth in intermediate and basic goods was least expected

Two consecutive months of negative growth in intermediate goods could indicate that the user sectors are seeing a contraction happening in the future. - DR PRONAB SEN, CHIEF STATISTICIAN OF INDIA

Harish Damodaran

Dr Pronab Sen is the Chief Statistician of India, who oversees the functioning of official data collection agencies such as the Central Statistical Organisation (CSO) and the National Sample Survey Organisation (NSSO). In an interview with Business Line, Dr Sen discusses recent trends in the Index of Industrial Production (IIP) and evidence of any possible slowdown.

Excerpts from the interview:

The latest IIP data shows that the slowdown is mainly coming from basic and intermediate goods, whereas capital and consumer durables are doing okay.

Yes, it is the first stage manufactured products covering a whole range of chemicals, steel and plastic products, components, yarns, etc., (which go into production of finished goods) that are facing the heat. Intermediate goods particularly have seen negative growth.

Could it just be a data blip?

No, because it’s happening for a second consecutive month. Intermediate goods fell by 6.1 per cent in August and 3.3 per cent in September. Initially, I saw it mainly in terms of a bottleneck problem. This meant I had a manufacturing sector which, at the finished product level (that is, capital goods and consumer goods sold to the ultimate buyer, namely households or firms), was growing at 10 per cent plus. On the other hand, there was the intermediate and basic goods sector that started its investment programme late in the day.

These happened to be capital-intensive, long-gestation projects that took off only around 2006-07, translating into production only towards the end of this year or next year. So, what I foresaw was a widening gap between the derived demand coming from the final user sectors and this demand not being met because of a capacity constraint.

In short, I expected a relatively slow growth in intermediate and basic goods and a fair amount of imports to cover this gap, which indeed happened in 2007-08. But negative growth is something that I least expected.

So, that means the reason lies elsewhere. Could it be deficient demand?

There is no evidence of a demand problem in the IIP data yet because the user sectors are still growing at a fast rate. Capital goods grew by 18.8 per cent in September and consumer durables by 13.1 per cent.

But all this is pre-meltdown data. Wouldn’t things have changed?

True, the domestic demand problem may be there. Two consecutive months of negative growth in intermediate goods could indicate that the user sectors are seeing a contraction happening in the future. And since these goods are usually ordered in advance, i.e., you stay ahead of the production cycle, orders are being cut.

If that is true, then you can expect a slowdown in the final user sectors to reflect in the IIP data three months down the road. It also seems that since the cost of credit is high, companies prefer to draw down their inventories.

Instead of working with three months’ stocks, they are now maintaining one month’s stock. In such a scenario, there will be less demand for intermediate and basic goods. An alternative explanation could be a simple supply side problem, meaning that these industries are not getting the credit needed for keeping capacities operating at the earlier levels.

How serious do you think is this credit crunch? The Reserve Bank of India data reveals credit growth of 30 per cent or more.

The RBI data only captures bank credit, which is merely one of the four sources of working capital — the others being trade credit, commercial paper and non-banking finance companies. All these three sources have just vanished today.

Trade credit is something we hugely underestimate; the balance of payments data shows it at around $40 billion last year. Even if these are international transactions, the fact is they support the working capital needs of domestic firms. Commercial paper issued by companies was again a major source for companies to raise short-term capital.

If all these sources have dried up, there would obviously be pressure on banks to substitute for them. There is no need, then, to get hypersensitive about this huge increase in bank credit. Moreover, since 2004, when the last development financial institution, i.e., IDBI, folded up, there has been no real source of long-term debt in the country. The void has been filled by the capital markets, external commercial borrowings or by way of banks rolling over short-term credit.

Take even a company like Reliance today, which has had to back down its cracker because it cannot extend trade credit to its overseas buyers. In our system, the whole shift from working capital credit to trade credit is done very meticulously: On a particular date, a company’s inventories and work-in-progress ceases to be the collateral and the letter of credit (LC) becomes the new collateral. That enables it to recycle or roll over its credit.

But today the bank here is refusing to honour the LC opened by a counterparty foreign bank (whose solvency position has turned uncertain post-meltdown) and extending trade credit against it. The company, then, has to stretch its working capital to cover the period till the LC matures, which means that much less credit available for production.

Any businessman will tell you: “Look my first priority is to sell what I have produced and only then to produce for the future.” So, the immediate hit is taken by production.

How does a classic slowdown or recessionary situation unfold sector-wise in the IIP? One would have imagined capital goods to take the first hit.

In an endogenous business cycle, capital goods is always the leading sector, considering its linkage to investment demand.

But that stage of capital goods production slackening and showing up in the IIP has not been reached yet. The reason for this is that the production now under way is against investment decisions made in the past and which are now being taken to completion. This process will go on till the middle of next year.

So, the L&Ts and the Punj Lloyds are basically executing old orders.

There are two issues here. The first concerns production of capital goods per se and the second is orders for new projects. In the present scenario, production will not get affected but there may be no new orders in the pipeline.

The relevant variable to track is investment demand and not output because output always follows with a lag in capital goods, given the gestation period involved. BHEL is today supplying orders that were booked three years back.

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