India’s growth rates have progressively risen from 4-4.5% during the 1970s to 5.7% in the 1990s and 7% during the current decade.
The breakaway from the low 3.5-4% growth rates during the pre-1980s era is a result of structural reforms across several sectors, which have resulted in strong growth in productivity and rise in investment rate. Given that India is still in the initial stages of development in the global productivity catch-up process, the step-up in growth, from the long-term perspective is a given factor. And from that perspective, attaining a 10% plus growth rate should not be too difficult.
high growth not the real challenge
While it is tempting to talk about 10% plus growth, what is more important is achieving higher growth with stability. Sustainable growth means potential growth without overheating. Empirical studies place India’s potential GDP growth at 8% factoring in the current level of investments and labour force. This implies the economy can grow at this rate without straining resources or causing a spike in inflation.
However, it would be unrealistic to assume such growth would happen immediately given that cyclical booms are always followed by cyclical slowdown, like the one we are now facing. Further, some of the recent gains in productivity may not sustain. India’s increased integration with the global economy also implies that it cannot grow at 8-9% while much of the world wallows in recession.
The implications of the cyclical slowdown (from the 2004-08 boom cycle) and a more severe global slowdown has resulted in India’s GDP (at factor cost) growth slowing down to 6.7% in 2008-09. The impact on the private sector has been more severe with both private investment and consumption slowing considerably. The headline growth in GDP at market price (including private spending, government spending and investment, and net exports) in the last quarter of 2008-09 was 4.1%, whereas if we were to exclude government consumption spending, growth was only 1.9%.
avoiding the debt trap
An important contributor to the higher headline growth is the huge rise in fiscal deficit. The combined fiscal deficit (both central and state) has risen sharply to over 10% of GDP from 5.5% due to expansionary fiscal aimed at offsetting the slowdown in private spending and decline in revenue collections. Increasing government debt, which is likely to rise to 78% of GDP, assumes that future growth will be strong enough to generate income growth beyond the debt service liability arising from rising public debt. A slower growth than the underlying real interest rate, can risk the possibility of expanding fiscal burden and unsustainable debt. Hence, from the policy perspective it will be important to commit to fiscal prudence. In this regard, phased withdrawal of fiscal stimulus will be keenly watched by the markets.
Though these risk factors are pertinent, the probability of India falling into a debt trap is low. The long-term potential GDP growth of 8% is much higher than the current cyclical lows. Given the large scope for improving productivity, medium-term potential growth could be higher. The potential growth probably has an upside bias given the strong investments seen in the last boom as reflected in average 40% growth in private investments during the period. Hence, as the demand revives in the next leg of revival, there will be sufficient capacities, and growth-interest rate spread will remain comfortable.
fuelling growth to the next level
The critical challenge for India is to continuously increase the potential growth beyond what is currently estimated. India’s high saving rate almost matches its rising investment rate, giving a sense of self dependency with regard to funding of domestic investments. Policy focus aimed at leveraging of domestic savings can go a long way in ensuring higher growth with stability.
Labour market issues are largely linked to non-availability of productive job opportunities rather than flexibility of the labor market alone. A large portion of the working population is engaged in the less-productive farm sector. While the recent employment guarantee programme has worked well in addressing this issue, it is still not a durable solution as the focus is more on income distribution rather than creation of enduring economic activities. Decentralisation of the growth potentials beyond the metropolitan centers is a critical factor that needs policy attention.
India also suffers from inadequacies on the infrastructure front which inhibits the realization of fuller potential growth. While the adoption of private-public partnership model for the sector was a step in this direction, it has failed to make significant progress due to issues around the project bidding processes, lack of administrative co-ordination, availability of resources and more recently due to non-availability of risk capital. Re-energizing the infrastructure sector can be a significant counter-cyclical initiative in itself.
implications for the market
In the immediate term, India growth is likely to be around 6% (headline growth), lower than last year, and will remain significantly lower than the potential growth of 8%.
In terms of the markets, the recent improvements in financial market conditions, including credit, equity markets and stabilising financial sector and fiscal spending are providing confidence to the economy. Expectation from the budget is high, with markets looking for concrete steps towards initiating significant reforms and invigorating the infrastructure sector. These have also been priced in into the market response, with broader indices posting nearly 65% returns from the March lows.
Improvement in risk perception and start of financial market re-leveraging has also resulted in pull back in commodity prices. In my view, the presence of large liquidity and emergence of green shoots may cause some extrapolative behavior as the underlying economy may fail to catch up with market expectations. This may cause short term volatility in the markets.