The Economist on India 5

The Economist on India 5



Too hot to handle

Nov 23rd 2006 | DELHI, HONG KONG AND MUMBAI
From The Economist print edition
Why the sizzling Indian economy is more at risk than China's

INDIA'S curries can be even hotter than the fieriest of Chinese hotpots; likewise the temperature of the two economies. Despite widespread claims that China's economy is overheating, actually India's shows more signs of boiling over.

In the year to the second quarter, India's GDP grew by an impressive 8.9%, while China's more up-to-date figures show even more breathtaking growth of 10.4% in the year to the third quarter. But to judge whether an economy is too hot, one needs to compare this expansion in actual demand with potential supply, ie, the sustainable rate of growth. Despite India's growth spurt in recent years, its sustainable pace is still much lower than China's, which puts its economy more at risk of overheating and rising inflation.

China's double-digit growth may look like a danger sign but there are few of the usual troubles. Inflation is only 1.4% and China has a widening current-account surplus, which implies excess supply rather than excess demand. Nor do asset price gains look particularly excessive. Average house prices have risen by less than 6% in the past 12 months. And share prices have gained only 42% in the past four years. Even the expansion of bank credit has slowed to an annual pace of 15%, not much faster than nominal GDP growth.

In contrast, India's economy displays an alarming number of signs that things have gone too far. Consumer-price inflation has risen to almost 7% (see chart), well above Asia's average rate of 2.5%. A recent report by Robert Prior-Wandesforde at HSBC finds many other signs of excess. For example, in a survey of 600 firms by the National Council of Applied Economics Research, an astonishing 96% of firms reported that they were operating close to or above their optimal levels of capacity utilisation—the highest number ever recorded. Firms are also experiencing a serious shortage of skilled labour and wages are rocketing. Companies' total wage costs in the six months to September were 22% higher than a year earlier, compared with an average increase of around 12% in the previous four years.

India's current account has shifted to a forecast deficit of 3% of GDP this year from a surplus of 1.5% in 2003—a classic sign of excess demand. Total bank lending has expanded by 30% over the past year, close to the fastest growth on record.

India's share and housing markets also look bubbly. Draft proposals by the central bank on November 17th to cap banks' exposure to stockmarkets and curb reckless lending only mildly dampened the optimism. Share prices are almost four times their level in early 2003. India's price/earnings ratio of 20 is well above the average of 14 for all Asian emerging markets. House prices have also gone through the roof: Chetan Ahya of Morgan Stanley reckons that prices in big cities have more than doubled in the past two years. Housing loans jumped by 54% in the year to June (the latest figures available) and loans for commercial property were up by 102%.

Indian policymakers seem reluctant to admit that economic growth has exceeded its speed limit over the past three years, let alone slow it. They prefer to bask in the belief that India has become another China, able to keep growing ever faster without inflation rising. Palaniappan Chidambaram, the finance minister, has said the Indian economy will continue to grow by more than 8% in the next few years.

India's trend growth rate has almost certainly increased but it is still nowhere near as high as China's. Mr Prior-Wandesforde estimates that it is now around 6.5%, up from 5% in the late 1980s. But India's recent acceleration largely reflects a cyclical boom, thanks to loose monetary and fiscal policy. The Reserve Bank of India has raised one of its key interest rates by one and a half percentage points to 6% over the past two years, but inflation has risen by more, so real interest rates have fallen and are historically low. This makes the economy more vulnerable to a hard landing.

India cannot grow as fast as China without igniting inflation because of its lower investment rate, particularly in infrastructure, and labour bottlenecks. The latest government figures, for the year ending in March 2005, put total investment at 30% of GDP, compared with over 45% officially reported in China.

Some, however, believe that an investment boom is under way. A recent report by Surjit Bhalla of Oxus Investments, an economic research firm and hedge fund, has caused a stir by estimating that investment in the year ending in March 2007 will reach between 38% and 42% of GDP. Such investment, he says, would allow India to sustain 10% annual GDP growth.

Sadly, Mr Bhalla's estimate for investment is almost certainly too high. Unless saving (29% of GDP in 2004-05) has also surged over the past two years, an investment rate of 40% would imply a current-account deficit (which must equal the gap between saving and investment) of close to 10% of GDP. This does not square with trade figures and, in any case, it would hardly be a sign of economic health. Nor does a significant increase in saving look likely given strong consumer spending this year and only a modest fall in the government's budget deficit.

When China's President Hu Jintao held meetings with the Indian prime minister, Manmohan Singh, in Delhi this week, they agreed there was room for both countries to prosper in their overcrowded corner of the world. It is, however, wishful thinking to believe that India can now run as fast as China without a higher investment rate and a more flexible labour market. The danger of red-hot curries is that they can leave one gasping and in tears.