Rating agency Crisil recently released a report titled State Of The Nation which looked at the economy and business landscape in India. The conclusions were divided into the good, bad and ugly.

Govindraj Ethiraj spoke to D K Joshi, Chief Economist at Crisil to get a overview of the report and also understand the headline numbers a little better. The takeaways don't sound so good but it would appear that there are slivers of good news which we might have ignored.

Here is a transcript and partially edited version of the interview:

Govindraj: Mr. Joshi, let us begin with the fundamental problems in the economy, and something that require urgent attention from all people concerned. How would you list them ?

Joshi: Well I think the most fundamental problem is external vulnerability, I think our current account deficit has only been rising which has increased our vulnerability to external shocks and we have seen that play out in the month of August when the rupee depreciated very sharply.

So I think from an emergency perspective that is the biggest problem that we face. I think that right now there is some calm but, if the US Federal Reserve starts its tapering again or there are noises that it is going to start its tapering again then, we could again see it impact our currency very adversely, and rupee could be again very volatile.

So I think that is from an emergency perspective. But I think if you move from the emergency, there are other emergencies building up for instance the manufacturing sector or the industrial growth in the economy. Industry has been slowing down very..very significantly and we now expect it to slow down to 1%.

Industry is the most labour intensive sector, over the years what we have seen is that not only is it slowing down but its ability to absorb labour has also been going down. So there are lot of worrying things on the on the industrial front. We need to address that, that’s very critical.

Govindraj: Industry contributes about 15 to 16 % of GDP, services contribute more than 50% and therefore to some extent betting on services to take us through any phase whether good or bad. What you are saying now is that services too is, directly linked to manufacturing and perhaps we are not cognisant of this as much as we should be.

Joshi: Well I think it is they are quite closely linked I mean when industry is not doing well services also can’t do well I mean that’s more or less given. If you look at the inter-relationship between them what we found that a decade back for instance you required 0.36 inputs units of service input to produce one unit of industrial output, today you require 0.44.

What it essentially means is the . .the service sector intensity of manufacturing activity has has increased so obviously it will spill over and what will services cater to I mean whether you take hotels trade restaurants they all cater to in some sense to industrial activity. I think when the income slows down obviously these sectors also start bearing the brunt of that.

Govindraj: So, is it also a policy failure to over emphasise the importance of services?

Joshi: I won’t say that , I mean services have helped us quite a bit in last couple of years but I think what is becoming evident that I think services is not an engine that can fly on its own. You cannot, for example expect the IT sector alone to lift such a large part of the economy. After all, it is only a small part of overall, it would be less than 8% of GDP. I think everything at this juncture is looking down. Only thing that is looking up is agriculture that ‘s the lone driver this year. If you look at industry and services which is about 86% of total GDP that is going to be worst than what it was last year.

Govindraj: So I am going to come back to agriculture in a moment, let’s look at other aspect which is perhaps either the bad or the ugly in the economy, which is rising inflation. Broadly, why has it been rising and what are the components that have caused it to rise the most?

Joshi: You can divide inflation into noise component and a signal component. I think signal would be the demand-driven inflation when the demand is exceeding supply that is measured through core inflation. The other things like foods or fuel are regarded as noise at this juncture.

What is happening is that you kept a lot of prices suppressed particularly fuel prices. They have to be released so I think that is going to cause pressure on inflation whether it is diesel or it is electricity for quite sometime so that pressure is building up.

Govindraj: So that’s about the future but why, did it come to where we are today ?

Joshi: Because, for example, we did not raise electricity prices for a long time and that led to the poor performance of state electricity boards. Somebody has to foot the bill and eventually I think the burden was falling on the Government and because the fiscal situation is bad there is no alternative but to lift prices up for this segment.

Govindraj: You say inflation is rising because prices of certain goods and services which should have been raised have not be raised, including fuel ?

Joshi: That’s right, that is one part. There is another part where I think prices are rising artificially like food. For instance, if you have such high stocks of rice and wheat, why is the food inflation or the cereal inflation still in double digits? There are problems with agriculture itself. You need to increase productivity particularly in protein segment. The kind of food stock we have, food inflation should not be there. So it’s also about management. Food inflation should be much lower.

Govindraj: How much inflation comes from food ?

Joshi: That would depend on whether you take wholesale price index or you take consumer price Index.

Govindraj: Let’s start with the wholesale index..

Joshi: I think in whole price index It has a very small percentage I think less than 15% but in ...in consumer prices the new index that has been constructed it is pretty large I mean almost about 50%.

Govindraj: So what affects you and me more ?

Joshi: Well I think it depends on in which income bracket you are and then the higher you go up the income bracket, food inflation affects you less and less. If you do a dipstick test, talk to an autowallah he’ll say I spend 85% of my income on food, if you talk to a CEO of company he’ll say may be 1% or so I think it varies.

But I think what we get from these indices is the national average I mean if, you know averages mask a lot of variations in the system. From an average perspective inflations is rising. More food inflation hurts the poor more. Its a tax on them there’s no doubt about it and fuel inflation affects almost everybody but obviously those the middle class will be affected much more.

Govindraj: So food, as you are describing it, is a supply side problem? Right, we are not able to manage our stocks. We are not able to distribute food or clothing or manage our supply chain therefore consumers are facing the burnt ?

Joshi: That is one aspect of one way of looking at it. The second way is in the last few years we have also created more demand for food. Rural wages etc have been rising very fast and I think that has created demand for proteins etc.

What is interesting there is that if you look at the inflation in protein category it has gone up almost 100% between 2004-5 and 2009-10. If you look at the protein consumed per person that has hardly gone up I mean that is almost stable. The point there is that people have got higher incomes so they are somehow willing to pay higher prices but the demand is high for these items so the prices keep rising.

Govindraj: Let’s take a step back then as a component of inflation understand food better. The problem seems to be that the tastes and needs have changed. People are consuming different kinds of food and are demanding different kind of food across the spectrum not just well to do but even someone who is economically backward ?

Joshi: Absolutely I think poor people move from the cereals to protein very quickly the moment there is a lift in their income. And I think that is why you see milk prices, eggs, meat, fish I think all of them have been in very high inflation zone for last couple of years.

So there has been a shift towards these, so there is more demand for them and since you don’t have enough supply prices keep rising. People are not cribbing right now because their incomes, particularly poor people’s have improved. Rural wages have risen by 17-18 % for casual workers.

Govindraj: Does that link again to agriculture to which we will come back?

Joshi: I think it links to also to some extent to NREGA in the sense that the proclivity of workers to leave their own towns and work outside reduces so that’s why there was shortage of workers in some categories which might not be so much this year because I think, economy itself is slowing down. In the last couple of years, yes, rural wages have risen fast. The pace of increase in rural wages has definitely slowed down this year.

Govindraj: You spoke of the cereals to protein transition. What is causing or pushing food inflation, how do other developing or developed countries manage this? Because they too must have seen this kind of transition.

Joshi: well, I think protein consumption I think particularly in Asia has been rising. What needs to be done is that you need to shore up supplies of these things and you need to have enough investments there and I think that’s what we are lacking. In milk production is rising but is rising too. So every time you go to the market you see a higher price tag on the milk. I think the only way to do it is through increasing... enhancing production.

Govindraj: So where do we stand on that , again as components of food how we, where do we stand on either increasing supply or increasing imports or adjusting the policies to do that.

Joshi: well, I think it’s a large economy I mean the moment we go out to import too much I think that will have an impact on global, we have seen it play out in rice and wheat whenever we try to import global prices tend to go up. So I think from that perspective it has to be dealt with domestically. I think agriculture is the only sector where we have a trade surplus. In most of sectors we have a trade deficit. While we export more than we import in agriculture.

Govindraj: What are the other components of inflation or is there any critical component of inflation which we need to touch upon before we move on to agriculture?

Joshi: I think in nutshell what we are trying to say is that what is typically regarded as noise or I think which Central Bank says typically don’t look at them. What has happened is that whether it is fuel or food the shock is not one-time, it is persistent.

Food inflation in India has averaged about 10% in the last seven years, a decade before it was 5% so there has been a fundamental shift up in food. And it defines your expecations. If you tell someone that food inflation will come down in the next two years, I don’t think many people will believe it. Even RBI surveys used to show that people have high expectations so it builds in to your expectations. After experiencing high inflation you start believing that it’s here to stay. Particularly for food I mean, that’s true.

Govindraj: Right, So, let’s talk about demand slow down now we touched upon it. You spoke of industry being in bad shape about growth being in 1%. Investments that came in were actually not able to create new jobs ?

Joshi : That’s right

Govindraj: And its more capital intensive and there is more automation and so on. What is the future looking? Future, as in the near future ? Is it cyclical, noncyclical and therefore something more permanent ?

Joshi: Part of it is cyclical because the economy is in a slow mood so the people I think there would be lay offs. But part of it is also structural I mean if your industry’s ability to absorb labour is reducing it’s not cyclical.

Govindraj: And that’s a global trend..

Joshi: I think we have for a economy which is going to add 12 million every year to the workforce This trend is not healthy because you have to eject people out of agriculture where will they find employment , I mean not all can be absorbed in services. The low scale worker has to find an employment in industrial or manufacturing sector and that I think is the big, big, challenge for us. You can’t keep feeding them through subsidies for long I mean you have to have a self sustaining employment in the economy.

Govindraj: Right, so what’s the reason for the demand slow down in the economy. In the way you would look at it ?

Joshi: Let me take you to through after the Lehman crisis because it’s five years since then. What happened was that the economy lifted very quickly because lots of stimulus was applied - whether it was fiscal policy or Government programs which were more consumption oriented. They pushed the economy up and interest rates were cut and that lead to a sharp increase in growth and we actually reached 9% within two years.

But what happened was the reality started biting I mean inflation started picking up because demand at that time exceeded the supply and the fiscal situation started worsening as a result of that they had to be pulled back on both. So the monetary policy became restrictive which essentially means that interest rates started rising and fiscal policy has to be contractionary which means the fiscal deficit needed to be reduced and Mr. Chidambaram actually did reduce it last year.

So what happens when you take these stimulants or the steroids off any individual. Unless the body his body is healthy the system will collapse. You weaned off the fiscal and monetary stimulus but the private sector was not in a situation to take the space vacated by the absence of stimulus.

And as a consequence - I am talking of private investments - you look at the pipeline of investments everything has narrowed quite a bit so in a situation where private sector was unable to accelerate on its own the economy slowed down. Private sector by the way contributes about 75% to India’s GDP. And private corporate investments have been hit really very hard in the last couple of years.

Govindraj: And for a lot of other reasons..

Joshi: So absence of stimulus and inability of the rest of the economy to accelerate on its own because of a vitiated investment climate I would say has led to this very sharp slowdown.

Govindraj: Right, my question also extends to consumer demand and I am assuming that’s what...

Joshi: Absolutely, if you look at demand GDP you notice private consumption demand growth which averaged around 8% over the last six to seven years was at 1.6 % in the last quarter. So that is about almost a 60% of GDP in private consumption that has taken a major hit.

Govindraj: And that’s really all about sentiment?

Joshi: it’s also because incomes are slowing. Whether you are buying a car or durable goods, when you have uncertainty of income or uncertainty of jobs you start holding or pulling back and I think that’s exactly what we are seeing.

Govindraj: But is that something that affects everyone. For instance, organised sector is about 7%, the 93% is really unorganised sector ?

Joshi: Yes..yes

Govindraj: Are you saying that all this applies to all the 100% of organised and unorganised the way they are consuming or the way they might curtail consuming ?

Joshi: I think what happens is that for the high end consumer items it is the organised. What the organised segment does today it also outsources to the unorganised segment, so I think this slows down so it does spill over to the unorganised in some way.

The only good thing this year is that the rural economy from the consumption perspective will hold on that is why we expect the tractor or two wheeler demand which is rural oriented to do better than but otherwise automobiles are in red zone.

Govindraj: I was interviewing Sunil Kant Munjal, Joint Managing Director of Hero MotoCorp a few days ago and he was saying the same thing. He felt a very strong agricultural turn around in demand plus festival season is going to be a clear kicker for demand at least for this year.

Joshi: That’s right, you are right I mean it can ...It cannot sustain growth over a long term but yeah, I think during the time when every no engine has no cylinder is firing I mean at least this one will help.

Govindraj: So, let’s talk a little more about the agriculture side . You are saying that it (growth) could go from 1.9% to 4.5% ?

D K Joshi: That’s right.

Govindraj: Which is a conservative estimate or it actually could go more?

Joshi: Depends. We have to wait because agriculture is very unpredictable, it’s not about rains and its distribution alone. Its also about the pests and other things. We have signals that agriculture this year should be good and 4.5% is a reasonable estimate. We have seen agriculture go up to 7.9% also in this decade over a bad year. Last year, it was bad statistically there is going to be some lift and then you have an exceptionally good monsoon I mean well distributed so that’s... that’s going to help this year.

Govindraj: So now that we are all thanking the rain gods, now when the monsoon have almost ended, what does this mean ? You talked about about tractors, two wheelers and so on but what could this better agriculture output and demand mean for the whole economy to what extent it can save us for the rest of or problems ?

Joshi: Agriculture is only about 14% of GDP so 86% of GDP is going to grow at a slower rate than last year so this cannot this doesn’t have the muscle to offset the head winds that you’ve seen in services and industry. But yes I think to give you a indication of what it can do suppose agriculture surprises much more on the positive side and it grows at 6% instead of 4.5 then over-all GDP goes up to 5.2% in our estimate. I think in a bad year its very good news.

Govindraj: But on the other hand, more than half this country by population is dependent on agriculture..?

Joshi: Absolutely, almost around 60% is in agriculture.

Govindraj: Right, so to that extent what you are saying means that at least more than half our population will in some way be taken care of despite the fact that the economy is slowing ?

Joshi: To some extent yes, because but a large part of it also depends on urban doing well. There is a growing linkage between urban and rural. What is important to remember here is the growth because of good agriculture and also the Government expenditure if you look at this year I think it’s still in favour of rural areas than urban areas so that’s also going to help.

Govindraj: Let me ask you, as we close, in six months there is election and that’s the end of the runway so to speak for the current Government. And we have not seen sufficient thrust as it turns out. So, what can be done to revive what’s not doing well ?

Joshi: Well I think one that is really crippling and which should be turned around there is some movement is the mining sector that hasn’t been doing well.

Govindraj: Because it’s been shut down in most places ?

Joshi: Yeah, absolutely and there is close linkage of mining with manufacturing. It spills over so if you grab these low hanging fruits, if you sort out mining which I hear are getting sorted out. If you do that then I think there will be immediate lift to rural because mining has been contracting. And we are importing iron ore today which we used to export I mean so that’s not only slowing the economy it’s also adding to external pressures

Govindraj: Correct

Joshi: So I think that is one segment - as far as reforms are concerned - I think there has been positive action. But if we start revving up the engines at the end of the runway it’s very difficult to make the plane fly off. But at least its revving up !

The good news from the policy side is most movements have been on the positive side so that helps create the sentiment. But I think the problems facing the economy require much more effort. Clearing the projects is another thing that we should be closely watching and whether the project pipeline is beginning to replenish or not, I think that to me will be more critical.

Govindraj: In some ways the message I am taking from what you are saying is that we seem to have lost sight of the real economy and its time to now bring attention back in more ways than one ?

Joshi: Absolutely I think yes if right now investment climate is not that healthy it’s because demand has also slowed down very significantly so reviving investments is going to be the biggest challenge particularly private corporate investment which is the most productive investment in the economy.

Govindraj: Right D K Joshi, thank you very much for speaking with us.

DK Joshi: You are welcome, thank you.