Below normal monsoon, but don146;t panic yet

The share of agriculture in Indian economy is rapidly shrinking as it did in all advanced economies. Agriculture8217;s share in GDP in 1991 was 33 per cent. By 2000 it had fallen to 25 per cent and now it is 21 per cent. Looking forward, we can expect it to fall further

The first monsoon forecast has arrived. It says that this year the monsoon is expected to be 93 per cent of the normal monsoon. Since there is a margin of error of 5 per cent, this means that the monsoon could be normal at 98 per cent, or lower at 88 per cent. Very soon, GDP growth forecasts based on the monsoon scenario will be produced by various think tanks and analysts. As the monsoon forecast moves up and down, models will be run, forecasting GDP growth rates for the year. They will contribute to changing expectations and moving stock market indices.

But is India still as sensitive to the monsoons as it is going to appear in the next few weeks? While it is true that a bad monsoon will immediately affect the incomes of farmers in unirrigated areas which constitute more than half the cultivated area and the poorer farmers in these areas will suffer a drop in consumption, the impact on the Indian economy as a whole is no longer as strong as it used to be.

When GDP forecasts based on the 8220;normal8221; or otherwise monsoon scenario come out8212;and before we start panicking8212;we should not forget that the Indian economy has undergone rapid structural change in the last 15 years. The share of agriculture in the Indian economy is rapidly shrinking as it did in all advanced economies. Agriculture8217;s share in GDP in 1991 was 33 per cent. By 2000 it had fallen to 25 per cent. Now it is down to 21 per cent of GDP. Looking forward, we can expect it to fall further.

However, in general, the models that are used to estimate the impact of the monsoon on GDP are backward looking, as are all macroeconometric models. Usually the elasticity that has been estimated reflect the response of the economy to the monsoon over an average of the last 30 years. This tends to overstate the impact of the monsoon on non-agricultural growth and on overall GDP growth.

The direct impact of the lower share of the monsoon is that as agriculture constitutes about 20 per cent of GDP, a one percentage point decline in agricultural production directly translates into only a 0.2 percentage point decline in GDP growth. This by itself makes a big difference. What makes an even bigger difference is the change in the linkages between the agricultural and non-agricultural sectors.

An important change that has accompanied the decline in the share of agriculture is the growth of foreign trade.

This has reduced the impact of agricultural performance on non-agricultural sectors. The linkages between agriculture and GDP arise from both the demand and the supply side. On the demand side, when agriculture does well, rural incomes rise. A rise in rural incomes leads to greater demand for industrial products. It has been seen that consumer goods do well when rural incomes rise. In some cases the impact is immediate, in others it comes with a lag. So, for example, the sales of shampoos, soap and bicycles might respond immediately, whereas the sales of motorcycles, fertiliser, tractors and TVs may have a lagged impact. The sharp increase in the share of manufactured goods that are exported in the last fifteen years have made manufacturing far more resilient to the ups and downs in demand associated with changes in farm incomes.

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On the supply side, increase in agricultural production increases the supply of food and raw materials. Cereals, fruit, vegetables, milk, meat, eggs etc. enter the consumption bundle of households. Their plentiful supply and lower prices, following a good monsoon, reduces the cost of living. Real incomes of both the urban and rural populations increase. They both have more to spend on non-agricultural products.

Also, there are a large number of industries that use farm products as raw materials. Products such as sugarcane, cotton and oilseeds are directly used by industry. Cheaper raw materials auger well for these industries. Again, the liberalisation of the external sector, greater options to import and the availability of resources to do so, has reduced the dependence of manufacturing on agriculture.

Further, many non-agricultural businesses may not do well when there is a bad monsoon and a fall in farm income. But today even the impact on their consumption is not as sharp as it used to be. Higher financial savings and physical assets as well as access to credit allows households, especially in urban areas, to smooth consumption and not add to the shrinkage in demand when there is a bad monsoon and their profits decline. In the period before the 1990s, a drop in agricultural growth rates were accompanied by a sharp drop in non-agricultural growth.

Manufacturing and services grow slowly not only in that year, but even beyond that year into the first few months of the next year. This has changed. The last time when GDP saw an actual decline was in 1979-80 a result of a very bad monsoon when agricultural output fell by a shocking 13 percent, and an oil price shock shook the world. Nor surprisingly, industrial growth declined by over 3 percent, and GDP fell by 5.2 per cent.

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But in 1990s, when agricultural output declined, though industrial growth slowed down, industrial production did not fall. Even when agricultural output fell by 7 per cent in 2002-03 a very bad monsoon, industrial growth remained positive at 6.6 per cent and services at 8 per cent. Overall GDP grew at 4 per cent. Last year 2004-05 when agriculture grew at 1.15 per cent, GDP grew at 7 per cent.

In summary, while the monsoons are important, especially for farm incomes and for certain industries, the impact of the monsoons on the overall Indian economy is often overstated. Today the Indian economy is far more resilient to the monsoons than it ever was.