It is very likely that the Indian economy entered a structurally different phase starting in 2003. GDP growth will exceed 8 % for the fourth year in a row. However, there are many who see this growth pattern as a blip. Just last month, the RBI somewhat surprisingly raised credit requirements to cause nominal interest rates to rise by 50 basis points. Given that inflation is likely to fall by at least a half percent over the next few months (oil prices have declined significantly, manufactured goods prices are stable and wholesale food prices have actually declined since September) this means that the RBI has through its policy, raised real interest rates by a minimum of 1 percentage point.

The RBI has embarked on this course because it feels that the economy has entered a significant "overheating" mode. It clearly does not buy the analysis of several economists (including this author) that the Indian economy has shifted gears to a 8 % plus growth path. Nor does the RBI put much weight behind the Planning Commission projections of a sustained 8 % growth profile. And obviously, the RBI believes that the PM is just being a politician, and not a respected economist, when he talks about the realistic possibility of a 10 percent growth profile in the near future.

The last time the RBI went significantly against the grain, and against growth, was in 1995 when, at least ex-post, it tightened way too much and brought the economy crashing down to a GDP growth below 5 %. The stock market also crashed, declining by over a third in a short space of two years (and well before the onset of the Asian financial crisis). Will history repeat itself in the near future?

That remains to be seen but if the RBI wants counter-cyclical policy, it should be very pleased with the figures on the fiscal deficit for this year. In November this year, as part of the IIC Mid-Year Review of the economy, I had offered some evidence to suggest that a large part of the "extra" growth that India had achieved over the last few years had gone into investment and not consumption. The investment rate (share of investment in GDP) had, according to my calculations, jumped to around 38-40 % in the current fiscal year, up some 8 to 10 percentage points from the 30 percent level prevailing in 2004/05.

The question raised by this forecast - where is the extra investment coming from? Answer - from domestic savings and most emphatically not from foreign savings (current account deficit). In 2005/06, the share of financial savings in GDP had already increased by 2.6 percentage points - from 14% to 16.6 percent of GDP (RBI Annual Report). Going by "historical" relationships between financial and total household savings, this implies that the household savings rate would have increased by at least 4 percentage points (ppt) in 2005/06, and most likely by an additional 2 ppt in 2006/7. This means that almost a 6 ppt increase in investment would have come about from just household savings.

The forecast for increase in the investment rate in just 2 years - 8 to 10 ppt. The real surprise is most likely going to be in the form of a significantly lower fiscal deficit (of both center and state). The consolidated fiscal deficit for the last three years as percent of GDP: 7.5, 7.3 and 6.3 % (budgeted, 2006/7). If the 6.3 % target is achieved, then the savings rate in 2006/7 would be approximately 37 % - forecast achieved and with no help from the rapidly increasing corporate savings!

How likely is it that the combined center and state fiscal deficit will be below 5 percent this year, well below the budgeted 6.3 %? Very likely. The budget deficit is an outcome of two variables - expenditures and revenue. Expenditures are budgeted, passed by parliament, and frozen, at least until the parliament authorizes additional expenditures. It is not unknown for expenditures to be increased during the year; on an average over the last seven years, central expenditures have overshot the budget by about 3 %. Assuming the same overshooting for state expenditures, it is possible that government expenditures will be higher by 3 % than budgeted, or about 1 % of GDP.

The other side of the story, tax revenues, has exceeded all budgets, and expectations. By November end, revenues were up 32 % over last year (April-November). There is little reason to think that the full year revenue growth would be less than this number. The budgeted revenue increase is 19 %. Tax revenues this year are likely to be higher by 2 % of GDP; if expenditure growth stays as planned (see table) then the fiscal deficit this year is likely to be well below 5 % of GDP and the lowest in the last thirty years. Even with some expenditure leakage, the budget target will be exceeded. So worst case scenario is for the central and state fiscal deficit to be close to 5 % of GDP i.e. an approximate increase in government savings of 2.5 percentage points since 2004/5.

If a small increase in the corporate savings rate is expected, then, in all likelihood, the savings rate in India in 2006/7 will be very close to 38 % of GDP; and an investment rate somewhere between 38 to 40 %. India has gone on an investment spree, not a consumption real estate binge as presumed by some. This is a structural change of a fairly robust magnitude. A decline in fiscal deficit of this magnitude (2 to 3 % of GDP) is counter-cyclical and contractionary.

Which raises the obvious question: was a drastic real interest hike of a 100 basis points, as engineered by the RBI, really necessary? The RBI should worry that its wishes may come true - the joint impact of a world economic slowdown and a very tight monetary policy may move the Indian economy from misperceived overheating to being undercooked.