Is red-hot India too hot?

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While most of the world is worried about the prospects of a double-dip recession, India is facing just the opposite problem – managing supercharged growth. The Indian economy, oblivious to the meager recovery in the West, is roaring. GDP surged 8.8% in the April-June quarter, the fastest clip in two-and-a-half years. There’s some debate among economists over what might happen next – some think growth has peaked for now, others think India may put up even bigger numbers in coming quarters. But either way, India’s performance will remain stellar. Goldman Sachs forecasts India’s GDP will surge 8.2% in 2010 and 8.7% in 2011. That’s behind the 10% or so Goldman expects for China in both those years, but not by much.

In fact, as I’ve argued before, India’s economy has actually emerged from the Great Recession is generally better shape than China’s. India has achieved its lofty growth rates without the potentially dangerous stimulus shenanigans Beijing used to keep growth going during the downturn. To compensate for slumping exports, Chinese policymakers flooded the economy with credit — building up possibly unsustainable levels of debt at local governments, potentially eating away at the health of the banking sector and fueling nosebleed-territory property prices. India didn’t have to take such drastic steps to survive the Great Recession, and thus isn’t suffering with the fallout. That’s because the sources of India’s growth are much more balanced than China’s. India isn’t as dependent on exports and investment as China, while private consumption in India plays a much bigger role in GDP growth.

Now, however, India is running into its own trouble – mainly, inflation. The wholesale price index in July jumped a hair-raising 10% from a year earlier. Though the inflation rate will likely start to trail downward in coming months, that doesn’t mean the problem is solved. I asked Frederic Neumann, an HSBC economist, for his views, and here’s what he said:

Most inflation readings will drop off in the coming months, because pressure from food prices is easing and the magic of base effects is setting in, dragging down headline readings. But, there is a lingering suspicion that official price indices are not picking up all price developments in the economy and might indeed understate the inflation problem. For example, despite strong employment growth, and presumably therefore wage rises, household spending continues to slow, suggesting that living costs are rising more sharply than earnings. Also, in the industrial sector, capacity shortages are evident, and price pressures continue to build as firms struggle to keep up with demand.

India’s central bank has been hiking interest rates to try to control the inflation outbreak, and Neumann and most other economists expect even more hikes to come. But nevertheless fears have emerged that India may be overheating. Here’s more from Neumann:

Unlike other Asian markets, which are more tied to the global trade cycle, India is grappling with risks of overheating. The economy hasn’t skipped a beat yet and forward-looking indicators suggest growth will hold up well into year-end, if not accelerate further…In short, unlike other economies that are starring at the risk of a double dip, India, with its vast internal market and limited export exposure, is grappling with the opposite problem. Both fiscal and monetary policy needs to be tightened in India to prevent the economy, already red-hot, catching fire.

There is some concern that India’s central bank hasn’t moved aggressively enough, perhaps dooming the economy to an especially hard landing. That’s the position of Maya Bhandari, head of emerging markets analysis at Lombard Street Research in London, who predicted a dire scenario in an essay in The Wall Street Journal last month:

The central bank has fallen badly behind the curve. Having administered huge doses of unnecessary policy stimulus, it has been lethargic in its withdrawal…The chief concern from here onward is that aggressive policy action will coincide with the worst point in the economic cycle…As might be expected, inflation has chipped away at consumers’ spending power. Based on available evidence, nominal incomes have not kept pace with average price gains. India is on course for its very own version of stagflation: 5% growth with double-digit inflation.

My own feeling is that Bhandari’s view is too alarmist. Yet India’s policymakers will now have to navigate through very tricky waters. They’ll need to cool down the economy enough to curtail inflationary pressures and prevent overheating – but, with the global recovery stalling, not too much, since India will have to rely on domestic sources of demand and investment to generate growth. Perhaps it’s a problem that other countries would love to have right now. But that doesn’t mean it doesn’t carry serious risks as well.

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