Will complacency on demand hurt revival?

India’s benchmark stock market index, BSE Sensex, breached yet another psychological milestone, crossing the 55,000-mark on August 13. This has come at the middle of the second quarter of the current fiscal year. Stock markets, provided they are not thriving on a bubble, are supposed to reflect future optimism (or lack of it) about an economy. The Nomura India Business Resumption Index (NIBRI) crossed the psychological threshold of 100 in the week ending August 15. A NIBRI value of 100 refers to pre-pandemic levels of economic activity. This suggests that the present state of economic activity is coming close, or has even surpassed pre-pandemic levels.

So, has the Indian economy finally shed its pandemic hangover? The answer to this question is less encouraging when we look at other recently released macroeconomic indicators. In fact, they underline the importance of focusing on revival of mass demand in the economy.

Poor demand outlook will continue to suppress ‘animal spirits’

Addressing members of the Confederation of Indian Industries on August 12, revenue secretary Tarun Bajaj asked why private investment was subdued despite impressive corporate performance (in terms of profits). Private capital makes investments only when it expects to make profits. Profits are a function of sales, which in turn is a function of demand. Investment, unless it is being made on account of depreciation of existing plant and machinery (or capital stock), is only justified when existing production capacity is deemed inadequate to cater to current or future demand. It is this constraint, not some ulterior motive, which is holding back private business from making investments.

The latest round of RBI’s Industrial Outlook Survey (IOS) offers clinching evidence on this count. One of the questions in the survey asks respondents about the assessment of adequacy (or lack of it) of production capacity at the time of the survey and expected situation in the next six months. The statistic which stands out in the survey findings is not the assessment about current adequacy of production capacity but the future assessment about it. An unprecedented 28.4% of the respondents believed that their existing production capacity is more than adequate for the second quarter (July-September) of 2021-22. The latest IOS round was carried out between April and June. What is remarkable about the perception about future production capacity being more than adequate is that it has increased significantly compared to the first lockdown and the subsequent first wave of Covid-19 infections, which peaked in September 2020. This could be a reflection of delayed realisation of demand side damage to the economy.

June quarter IIP numbers highlight damage to discretionary demand

Some of the sequential economic recovery after a pandemic-like shock is inherent, as things will come back to normal. For example, people will go for haircuts and children will buy school uniforms once restrictions are eased. This is often described as pent-up demand. What matters for a sustained recovery, however, is whether there is any damage to what is often referred to as discretionary demand. This can happen when consumers, facing a current and future squeeze on their incomes, start cutting back on various kinds of non-essential spending. A new car or television, a family vacation etc. would fit in this category.

Evidence from the June quarter Index of Industrial Production (IIP) numbers suggest that this seems to be happening in the Indian economy. The IIP index in the June 2021 quarter was lower than the June 2019 value, which means that industrial activity has not returned to pre-pandemic levels. A comparison of different components of the IIP for the June 2021 quarter with their corresponding values in the June 2019 quarter supports the argument around discretionary demand being weaker.

At the use-based level, capital goods (lack of investment demand) and consumer durables (lack of discretionary demand) show the biggest deficit vis-a-vis pre-pandemic levels. Consumer non-durables, on the other hand, show the smallest contraction. At the industry level, the only three industries which had recovered to pre-pandemic levels in the June 2021 quarter were manufacture of food products, pharmaceuticals and basic metals, all of which are essential in nature. Transport equipment, furniture, motor vehicles etc. show the biggest deficit on this count.

A ‘terms of trade’ shock to rural demand could be on the way

Agriculture was the only silver lining in the economy in the last fiscal year. Barring any unforeseen climate shocks, agricultural production should continue to grow in 2021-22 as well. However, agriculture’s contribution to overall demand in the economy is also contingent on what is described as ‘terms of trade’ or relative prices of farm and non-farm goods in the economy. If prices of non-farm goods are rising at a faster pace than farm-products, then farmers will face a squeeze on their purchasing power, which will generate headwinds for overall demand.

Given the fact that it is non-food inflation which seems to be driving headline inflation numbers at the moment, a ‘terms of trade’ shock to farm incomes and therefore rural demand cannot be ruled out. To be sure, headline numbers for food and non-food inflation underestimate the possibility of such a situation, because food inflation has been elevated by prices of commodities such as edible oils, pulses and meat products. Prices of cereals and vegetables, which account for almost half of the value of crop production in the country, have actually been contracting for six months now. This is not good news for incomes for majority of farmers in the country.