Capital investments seem to be the only strong support for overall GDP growth when the global outlook is getting weaker. How long can it sustain? By Vivek Sharma

Last year, when a handful of cautious commentators raised the possibility of a growth slowdown, it was easy to dismiss them as pessimists. The Indian economy was doing far better than ever before, domestic demand was strong, asset prices were seeing a sustained rally and inflation seemed under control. We watched with amused smugness the unfolding US sub-prime crisis and the wider credit market drama from the sidelines reassuring ourselves that India was well cushioned from the US markets. Our stock markets were on fire and all was well, with our world.

But, good times don't last forever. Confirming the weak signals visible towards the end of last year, the Central Statistical Organisation (CSO) has said it expects 07-08 GDP growth at 8.7 per cent. That number may appear pretty impressive on the face of it, but it is nearly a percentage point lower than last fiscal's revised growth rate of 9.6 per cent.

The CSO estimate came as a big surprise when most forecasters were confident of growth rates above 9 per cent. NCAER, the country's premier economic think tank, was confident enough to hike its forecast to 9.1 per cent in January, up from 8.9 per cent earlier. CMIE, the leading private forecaster, had also predicted growth of 9.1 per cent, though the RBI's forecast was a more cautious 8.5 per cent.

The finance minister, who was very confident that growth would hit double digits by next financial year, believes the CSO is being very cautious. He says agriculture growth should exceed the forecasted 2.6 per cent, as his colleague at the agriculture ministry believes so. It might well turn out be so and growth may exceed 9 per cent for the third successive year, when the estimates are revised.

But, undoubtedly, the short- to medium-term economic outlook is getting cloudier. Prospects for the next financial year have tuned weaker, in line with the worsening global scenario. To make it worse, rising inflation is making it increasingly difficult for the RBI to cut rates and support growth.

Manufacturing and construction decelerate
Manufacturing growth has been accelerating for the last few years and it was widely perceived that the sector has taken off, despite poor infrastructure and other systemic shackles. We all talked about the rising competitiveness of Indian manufacturers, just when the Chinese looked all set to render most manufacturers jobless. But, the pace of growth seems to have slowed down this financial year - to 9.4 per cent from the high of 12 per cent during the previous year.

The slowdown could be partly because of the high base effect and the rest due to currency appreciation and higher interest rates. Manufacturing exports have struggled this year, because of the strong rupee. This is mostly restricted to low margin goods like garments, where exports are set to fall this year after last year's strong growth. It is unlikely that these labour-intensive and low-margin sectors will regain their growth momentum, especially when their major market is facing a recession, unless the rupee depreciates.

Higher interest rates have also led to a slowdown in domestic demand for durables. Two-wheeler manufacturers have been reporting lower volumes for the last few quarters and growth in car sales has been in single digits for the last many months. Commercial vehicle sales growth has also declined. Volume growth in consumer durables is also not very encouraging, despite hopes of growth in organised retail bringing in additional volumes.

Construction growth for the full year is forecast at 9.6 per cent as compared to 12 per cent for the previous year. Credit flow growth to the real estate sector has nearly halved this year, probably because of tighter lending norms. Demand for residential property has slowed down appreciably, though prices have not seen any meaningful correction.

Home loan disbursements by leading players like ICICI and HDFC grew only marginally during the October-December quarter. Builders have started coming out with promotional schemes to push volumes. Larger and established builders are dumping unsold space to private equity investors. There is still demand for commercial space in big cities, but with increasing supply, prices have moderated.

Consumption falters, but capital investments remain robust
The strong domestic consumption growth was the pet theme of those who had staunchly advanced the 'decoupling' theory. Until recently that is, as there are not many true believers of that theory anymore. But, private consumption growth has clearly slowed down.

Personal loan growth has slowed down to 20 per cent from 35 per cent last year, according to the last RBI report. Delinquencies are rising in credit cards and personal loans, and some of the larger players like ICICI are said t have exited the small ticket personal loan segment. Consumer durable financing has actually declined despite the financing subsidiaries of large retailers commencing operations.

Aggregate non-food credit growth has declined to 22 per cent during the first 9 months of this fiscal, from nearly 32 per cent during the previous financial year, and most of the growth was in industrial credit. Declining credit demand is the prime driver behind the latest round of interest rate cuts by major banks.

But, capital investment growth remains very strong. CSO estimates gross fixed capital formation growth for the current fiscal at close to 16 per cent, which is very impressive considering higher interest rates. Even when industrial growth slackened in recent months, most of the deceleration was in consumer goods while capital goods output growth remained in high double digits.

Yes, we do have an inflation problem
One of the most comforting developments of last year was the decline in inflation. When the rate of inflation halved from its peak set in early 2007, only partly because of the earlier rate hikes by RBI, it was reasonable to expect that prices would remain under control even if retail fuel prices were hiked. That no longer seems to be the case.

Inflation for the latest reporting week has topped 4 per cent, even without the ever-delayed fuel price increase. With a modest increase in fuel prices, the rate of inflation could move past RBI's target of 5 per cent for the current financial year. Yes, if the government can postpone the price hike this long, it can be postponed forever. But the RBI cannot afford to buy into this 'make believe' low-inflation scenario. That means it would be difficult for the RBI to cut rates to any meaningful extent, any time soon.

Crude oil prices have declined this year in anticipation of a US recession. But, most oil analysts believe prices may not fall substantially even if the US goes through a prolonged recession. Apart from steady demand in other major consuming countries providing some cushion, they expect OPEC to lower production and support prices.

Even if oil prices decline and the government is spared of the politically difficult task of hiking fuel prices, there are other factors, which can increase inflation risks. Food prices remain firm and wheat output is expected to fall short this year as well, which may worsen the situation.

How long can the investment boom prop up growth?
It is clear that the economy is now mostly running on one leg - capital investments. The sustained growth in capital goods output and gross capital formation indicates that industry is going ahead with capacity additions, despite the slowdown in consumer demand. Not many expect the global deceleration to prolong, as there are many who predict strong growth in the US by the second of this calendar year. Will this optimism last?

It is possible that capital investments are relatively unaffected because of easy credit availability. Despite the interest rate hikes last year, borrowing costs of prime corporate borrowers have not increased proportionately. Interestingly, infrastructure and manufacturing accounted for most of the credit growth during the first nine months of this fiscal.

Another factor was the sharp surge in external commercial borrowings by domestic corporates. But, RBI has been actively discouraging external borrowings to arrest rupee appreciation. The global credit crisis could also lead to a slow down in foreign currency borrowings this year. The stock market correction has led to an absolute freeze in the IPO market, temporarily shutting down another source of capital.

Many large projects in the sectors like steel and power are getting delayed because of opposition to land acquisitions. Many of the large SEZ projects could also get delayed for the same reason. All these could mean a slowdown in capital investments, which could pull down aggregate growth further during the next financial year.