Manas Chakravarty: A tale of two droughts

Structural & cyclical changes in the economy have helped make industry more drought-resistant

Now that we're more or less certain that this year's monsoons are going to be far from "normal" whatever the Met Department may say, the question that everybody is asking is, "How bad is it going to be?"

It's early days yet to guess exactly how badly industry is going to be affected, but the markets have already turned jittery.

Despite the bounce in the Sensex this month, stocks such as Hero Honda and Bajaj Auto have been punished, while stocks of fast moving consumer goods (FMCG) and cement companies have not gone anywhere.

Most of the action in the markets in recent weeks has been in tech and steel scrips, which are well-insulated from any drop in rural demand.

One way to gauge how badly a poor monsoon will affect industry is to look back at recent drought years and check the impact on manufacturing.

In 2000-01, for example, growth in the agriculture, forestry and fishing segment of the economy was a negative 0.1 per cent. Chart 1 shows that manufacturing growth was pretty good that year, with the annual rate of growth being a high 7.4 per cent.

But considering that the impact of a drought is felt in the last two quarters of the fiscal year, the annual growth figure would be misleading, because the effect of a poor harvest affects industry with a lag.

For instance, that manufacturing growth showed a sharp drop from 7.9 per cent in the third quarter of FY 2001 to 5.4 per cent in the fourth quarter.

Thereafter, it was downhill at a rapid pace for the manufacturing sector, with the rates of growth braking to 3.2 per cent and 3.3 per cent in the first two quarters of FY 2002.

It wasn't before the second quarter of FY 2003 that manufacturing growth went back above 6 per cent, thanks to the lagged effect of the previous year's good monsoons. Clearly, manufacturing was severely affected by the drought in FY 2001.

Yet the impact was dramatically different during the severe drought of 2002-03. In that year, agricultural production fell by 5.2 per cent, with the steepest fall occurring in the third and fourth quarters. The drought in 2002-03 was accordingly far more serious than the one in 2000-01, when agricultural production fell by just 0.1 per cent.

But, as the chart shows, apart from a marginal fall in manufacturing growth from 7.3 per cent in the fourth quarter of 2002-03 to 6.6 per cent in the first quarter of the next year, manufacturing growth remained well above 7 per cent in 2003-04. That buoyancy was markedly different from what happened to the manufacturing sector in 2001-02.

Why did the droughts of FY 2001 and FY 2003 have such differing impacts on manufacturing? What changed in the Indian economy between those two years? Has the economy become drought-proof? These are the questions that need to be answered before an assessment of the effect of this year's drought on industrial production can be made.

The Economic Survey of 2001-02 contains some clues. The Survey says that, "The sharp deceleration in overall industrial growth is due to a number of structural and cyclical factors such as normal business and investment cycles and lack of both domestic and external demand."

In other words, the economy in 2001-02 was in the trough of the domestic business cycle, while the collapse of the tech boom of the late 1990s had considerably weakened the external environment. The Survey goes on to list some of the other problems, such as high real interest rates and infrastructure constraints.

In contrast, the Economic Survey of 2002-03 noted several improvements, such as low interest rates, growth in consumer finance and strong export demand as conditions that contributed substantially to the industrial recovery. A reference was made to the closer integration of sectors of the economy, such as auto ancillaries, in global production chains.

The Survey also pointed out that, "The demand generated by enhanced public investment in physical infrastructure has been a key stimulant behind industrial recovery. The impressive progress of the National Highway Development Project (NHDP), one of the most ambitious highway projects in the world, has provided strong backward linkages for the steel and cement industries."

The six core industries showed a rate of growth of 5.4 per cent in 2003-04, a rate considerably above the 2 per cent rate notched up by these industries in the first three quarters of 2001-02. The telecommunications industry showed explosive growth, thanks to deregulation and competition. The rise in commodity prices also contributed to the recovery.

In short, rising exports, consumer financing, low interest rates and the highway project, all led to an increase in demand, and this increased demand was more than sufficient to offset the depredations of the drought.

Continuing rapid urbanisaton and the growth of the services sector, especially the explosive growth of sectors such as IT and business process outsourcing (BPO) means less dependence on rural demand. What's more, the business cycle had turned by 2003-04, with most companies operating at close to full capacity "" this markedly improved the business climate.

The cyclical upturn is evident from Chart 2, which shows that while capital goods production contracted at a rate of 3.4 per cent in 2001-02, it grew by as much as 12.7 per cent in 2003-04. In short, in 2001-02, when all these positive factors were either absent or not strong enough, the effect of the drought was much more marked.

The question is: will the manufacturing sector be drought-resistant this year too? Let's take the factors one by one. First, exports have been doing well, and if the consensus projections of a rebounding global economy are true, then exports will continue to be a robust source of demand.

Next, the highway programme continues, but the trouble is that demand from this sector may be maintained at last year's rates, which means that it will no longer be an incremental source of demand. Consumer financing will continue to expand, but the main worry is whether a rise in interest rates will choke consumer demand. That could, however, be offset by the proposed doubling of credit to agriculture.

Moreover, because they are operating at near full capacity, corporations have been announcing expansion plans almost at the rate of one a week "" this indicates that investment demand will soon kick in, providing added impetus to growth. Also, if this year's drought is not as bad as the one in 2002, then that could well be the biggest item on the credit side.

In short, the Indian economy has come a long way since the manufacturing slump of 2001-02, with several structural and cyclical changes helping to offset the impact of a drought on industry. Whether they will work as well as they did in 2003-04 is something we will know soon enough.