Indian industry's three-year itch

How long is the current industrial recovery likely to last? Going by historical evidence, another two years. Cyclical upswings in Indian industry have followed a surprisingly uniform pattern and have lasted for exactly three years.

Data suggests that we have already seen a little more than a year of a rebound -- hence the prognosis of the recovery lasting for roughly two more.

But first, what does a cyclical recovery mean and what implications does it have for business? Economists like to segment economic growth into a trend or organic component and cycles. These are simply deviations from this organic component.

An upswing is simply a positive deviation or a movement above trend. Organic growth represents the "business as usual" scenario -- it is driven by long-term factors such as population growth, increased penetration of products and steady capital accumulation.

Cycles on the other hand are driven by "positive" or "negative" shocks that could take the form of a bumper harvest, low interest rates or a surge in public spending. The triggers for the current up-tick are fairly easy to identify -- large public spending on the highway

programme and low interest rates that spurred spending on private housing.

What happens during an upswing? Crisil's analysis of cycles in the sales of sectors such as commercial vehicles and cement shows that firms see both a dramatic improvement in their sales as well as operating margins during an upswing.

The latter follows from a rise in pricing power: buoyant demand enables firms to charge higher prices that jack up the per unit difference between average prices and average costs. This in turn translates into greater profitability.

Some of the sharp spikes in operating profits during the initial phase of the upturn in sectors like cement could also mean that price cartels work effectively during an upturn and break down when the cycle reverses.

An analysis of Indian industrial GDP data (at constant prices) from 1970-71 to 2002-03 shows that upswings last for exactly three years and peter out immediately. Downturns are difficult to predict and show a high degree of randomness.

The methodology of this exercise involved running a very fine trend (a Hodrick-Prescott Filter) through the data and measuring the deviations from this trend. Using constant price data (1993-94 prices) helped us net out the price effect to get a fix on the "real" growth in industrial output.

Surprisingly, the large structural change in the form of liberalisation in the 1990s does not seem to have made a difference. The upswing in the mid-nineties lasted for just three years, exactly like upswings in the pre-liberalisation phase.

Is there an underlying story that explains this phenomenon or is this just a statistical coincidence? Our guess is that the three-year blips tell us a lot about the way the Indian economy responds to shocks. Let's take the case of inventory adjustment.

Economic theory posits that one of the ways in which upswings are set off is through inventory accumulation by firms in response to interest rate declines. To put it in simple words, manufacturers "stock up" in response to lower cost of holding these stocks.

A three-year cycle would suggest that for the manufacturing sector as a whole, the process of restocking takes about three years and then fizzles out. It could also mean that spending binges by consumers in the wake of a revival in their incomes (say a rise in rural incomes on the back of a good monsoon or a public works programme) lasts for about three years on the whole.

The strategic implications for Indian companies of this regularity is fairly obvious -- medium term sales planning and pricing has to take the duration of the cycle into account. The same holds for capacity expansion -- firms that set up capacity anticipating a sustained rise in sales could be seriously disappointed.

This is exactly what happened in the mid-nineties when Indian manufacturers went on an asset expansion binge, hoping that demand would continue to grow rapidly over the long term. What resulted was one of the worst slumps in Indian economic history lasting for four years.

If history is likely to repeat itself and the upturn indeed lasts for just two years, Indian companies need to pare down their sales and profit forecasts from 2005-06 onwards.

While the uniformity in the duration of upswings makes it easy to forecast, it does have a sense of fatalism about it. It implies that no matter what the changes in the structure of the economy, it can do little to change the cyclical patterns. The recent experience of developed economies shows that it is not necessarily true.

Business cycles in the UK, for instance, appear to have been ironed out to a large extent from the early 1990s due to a combination of better fiscal management and a growing bias towards the services sector.

The recent recession notwithstanding, the US saw continuous economic expansion in the 1990s on the back of shrinking budget surplus and improvements in productivity. After, opening up in the mid- to late-eighties, the east Asian "tiger" economies saw high and uninterrupted growth for a long period.

Some economists argue that the Indian economy has seen similar structural changes and that should help sustain the current recovery beyond the three years seen in the past.

They point to the fact that Indian companies have also seen rapid changes in productivity largely due to better inventory management and work force rationalisation. Interest rates have not only hit historic lows but the benefits of low rates have started flowing to a large chunk of the domestic manufacturing sector.

The services sector is on roll and with new areas like business process outsourcing opening up rapidly, the sector is unlikely to lose steam rapidly.

The jury is still out on whether the current cycle will last beyond three years. "Technical" analysts who believe that "past patterns" hold the key to the future are likely to swear that this time things are no different and the upswing will fizzle out after a couple of years.

The "structural change" camp will keep emphasising how things are. Whatever the final outcome firms and investors would do well to keep this three-year itch in mind.

The writer is a senior economist at Crisil

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