The outlook for the economy has turned for the worse in the last couple of months, as economic data has fallen short of expectations. Even as inflation continues to be the biggest worry, domestic political uncertainties also pose significant risks to growth over the medium term. By Shivshanker Verma

Those who have travelled to any of the southern states recently can't be faulted for believing that it is still summer out there. After many years of 'planning to do it', I had booked a 'Monsoon Magic' package tour in Kerala well in advance for my family. Finally when we landed there in the last week of June, there was no monsoon. Though the backwaters were every bit magical as they were promised, the kids were disappointed at not being able to 'revel in non-stop rains' as the tour brochure had put it.

Going by recent developments and economic data, it is likely to be an extended, and parched, summer for the Indian economy as well. The rains are not quite the problem. With the measured confidence that is its hallmark, the meteorology department has been assuring us that, up to 15 July, 'on the whole' monsoons were in fact 6 per cent above normal. The department has also forecast that rains may weaken during the second half of July, but we are all set for yet another 'normal' monsoon this year. That will be the fifth or sixth year in a row.

Probably enthused by the meteorology department's optimism, the agriculture minister decided to briefly take his attention off his more weighty responsibilities as the czar of cricket to talk about farm output. Last year the output of wheat, maize, coarse cereals and cotton were all above earlier estimates, the minister said. That should perk up overall GDP growth for last year in the final estimates, when it is released later.

As prices of most agricultural commodities remain high and monsoons are good, total area under cultivation for most crops should increase this year. So nothing much to worry about, the farm sector will do well this year too.

It is the star performers of recent years, services and manufacturing, that are under a bit of heavy weather now. May industrial growth was at a six-year low. Salary growth in the services sector was much lower than in the recent past, a clear indicator of a slowdown.

The decline in property prices will limit growth in construction, which in turn will further dampen industrial growth in coming quarters. Even the finance minister, who was confident that double-digit inflation will be a very short term phenomenon, now says pressure on prices may continue for many more months. That means, the RBI will continue to hike interest rates and overall demand growth will slow down further.

Capital investment slowdown
Earlier this year, even when most indicators pointed to the likely growth slowdown, the big hope was capital investments. Encouraged by the steady demand growth and easier capital availability, industry had lined up very large projects to add capacity. The investment boom was quite unprecedented, in size as well as spread across sectors.

Estimates of the total size of project investments that were in the pipeline varied from $500 billion to as high as $800 billion, to be implemented over a 5 year period. The first estimate was by ICICI Bank and the second one by Projects Today, a Mumbai-based consultancy.

This huge spending on capacity addition was expected to lift demand for capital and industrial goods, and support aggregate GDP growth. The high growth rate of capital goods output over the last year and first quarter of this calendar year supported this view.

As interest rates have increased and stock market have slipped, the confidence has waned. Most companies are now believed to be postponing their investment plans. The best example is the steel industry.

A couple of years back, at least half a dozen steel manufacturers announced mega greenfield plants of 10 million tonnes or more. None of them are anywhere close to start of construction. It is true that some projects like the Posco plant in Orissa are delayed because of controversies related to land acquisition and resettlement. But, other steel companies are hardly showing any kind of urgency to speed up the proposed projects.

The story is no different in the power sector. Only Tata Power and Reliance Power are going ahead with the implementation of new projects, including the ultra-mega power projects. Both Sterlite and JSW who had proposed large IPOs to fund power projects are now unable to raise capital in a weak market. Enthusiasm among potential bidders for the ultra-mega projects is low, only Reliance Power was seriously interested in the last such project offered for bidding.

Then we have the proposed oil refineries and petrochemical projects. ONGC is no longer talking about a proposed Rs25,000 integrated petrochemical complex in Mangalore, announced with much fanfare a couple of years back. Indian Oil, HPCL and BPCL have been talking about various greenfield refineries and capacity expansions across various locations now. It has been in negotiations with various partners, ranging from global companies like Total to state-owned oil companies from the Persian Gulf, at various points.

The only potential partner still interested in these projects seems to be Lakshmi Mittal. In any case, the PSU oil companies will find it impossible to raise enough resources to execute these projects when they are struggling to remain solvent.

The other great hope was increased infrastructure spending by the government. Ever since it came to power, the UPA government has been steadily increasing its infrastructure investment targets. The last quoted figure was something like $480 billion over the next decade or so. It is good to have such lofty ambitions, but where is the money? Fiscal deficit is all set to shoot up to 6.5 per cent of GDP this financial year, according to some estimates, against the finance minister's ambition of 2.5 per cent.

It is unlikely that the government can find additional resources this year to step up infrastructure investments in a big way. Reports suggest that work on even high profile projects like the highway expansion programme have slowed down considerably. The next government will inherit the huge fiscal deficit and will find it difficult to increase spending on large projects.

The industrial growth data for May validates this view of an investment slowdown. Output growth for capital goods slipped sharply in May to just 2.5 per cent, from 11.4 per cent for the previous month. If the RBI hikes interest rates further, the recovery will take longer as monetary policy changes show up in output numbers only after a year or so.

Threat of a rating downgrade
This week, when Fitch downgraded the country's local currency rating to negative, it was not a surprise to anyone but the government which called the move unwarranted. It is true that Fitch, and the bigger and more influential rating agency S&P, continues to maintain their positive outlook on India's foreign currency rating which is more relevant for foreign investment inflows. But, the signs are ominous.

In their most recent reports, both S&P and Fitch have warned that the likelihood of downgrading India's sovereign rating has increased significantly. If that happens, the government will have only itself to blame as the biggest culprit is rising fiscal deficit. At present, India is rated at the bottom rung of investment grade and a de-rating will push the country down to speculative grade.

A downgrade may not entirely dry up foreign investment inflows, but will definitely make foreign investors more wary, despite the country's significant long term potential. This will be all the more significant when global credit markets remain edgy and most investors are running away from risk.

How low can it go?
Till a month back, most economists were willing to bet on current year GDP growth coming in at around 8 per cent – much lower than last year, but still very respectable.

As inflation crossed double-digits and industrial growth numbers slipped, the forecasters have also become more disheartened. Most of them now expect a growth rate of around 7.5 per cent, if the farm sector does well as expected. The more pessimistic are now willing to take their forecasts below 7 per cent. CMIE remains the only optimistic forecaster and continue to hold on to their earlier forecast of 9.5 per cent.

The biggest risk is of course inflation. If prices continue to rise, interest rates will go up at a faster rate and bring everything to a standstill. But, oil prices may correct in the short to medium term as global energy demand is clearly easing, unless there are adverse political developments in the Middle East. Higher farm output should bring down domestic prices of agricultural commodities in the coming months. Hence, it is likely that inflation will come down before the end of this calendar year and ease the pressure on the RBI.

The other risk is domestic political uncertainty. Political realignments after the government's last ditch attempts to push the nuclear deal have been unexpected, with the possibility of a Left-BSP-UNPA third front becoming stronger. If there is no definite mood swing in favour of any of the three alliances – UPA, NDA and the emerging third front – a hung parliament is a distinct possibility. That will make the outlook murkier, and worse still, it may take a while before the dust settles down.