What is India's potential growth rate?
Aug 21 2012, 13:00 | By CNBC-TV18
A slew of economists have cut India's GDP growth this year to 5.5% from 7.5% earlier. Some others have questioned whether we are a 7.5 or 8% economy at all. So what is India's potential growth rate?
Potential growth is the rate at which an economy can grow without creating serious imbalances like high inflation or big deficits. Western economists define potential growth as that unemployment rate below which inflation rises above trend.
The Reserve Bank of India (RBI) in its latest macroeconomic report of July 30 states, "the potential growth rate which is the maximum growth rate that the economy can sustain without creating macroeconomic imbalances, moderated during 2009-10 to 2011-12 from around 8% to 7.5%."
CNBC-TV18's panel of economists Dr Pronab Sen, Advisor to the Planning Commission, Jahangir Aziz, Chief Economist with JP Morgan, formerly Advisor with finance ministry and Samiran Chakrabarrty, Chief Economsit at Standard Chartered Bank give their take on India's potential growth. With the country's inflation having ticked lower, the panel also analyse whether the long night of climbing prices is finally easing or not yet.
The economists also talk about India's social development - girls in schools, underweight children, and life expectancy with some hard hitting and compelling numbers.
Below is the edited transcript of the interview.
Q: Do you think that there is a case to lower India's potential growth to around 6%? What is the data you employ; is there enough in the CSO's database, in the survey of industries to be able to actually calculate a potential growth rate?
Sen: Yes, indeed there is. Let me start with your question is there a case to lower the potential growth rate? Yes, In fact, when we did the 11th plan in 2006, the estimate of the potential growth rate was 7.8%. Now that was based on two critical parameters; firstly, the world economy was doing extremely well, and therefore, to get a 15-20% growth in exports didn't seem that difficult.
The second critical parameter was the savings rate of the government, which because of FRBM had been increasing steadily or improving. So, 7.8% was where it was at. We said 9% for the 11th plan because we were on the uptick of the business cycle and we thought that it would last for about 4 years. Even if there is a mild downturn, it would still be above trend, and so, 9% looked quite reasonable.
Today, when I do the same calculations again, I am not getting a 6% growth rate but 7.2%. It is again based on two factors, which is the world economy is down. If we can do a sustained export growth of somewhere around 8%, we should be okay. I am assuming that the government will stick to the fiscal correction that has been outlined, which will give a 7.2% on a sustainable basis.
Q: You have been arguing that there has been a seminal fall in the capex of India Inc. What's your sense with this 7.2% number? Would you say that that's a tenable figure?
Aziz: Let's start with the first problem, which is potential growth. Among the four of us, we understand what potential growth is but, in general, it is a very dangerous topic to talk about because there are lots of aspirational, nationalist elements that come into potential growth.
Again, let me reiterate - it is just the growth rate. It is a technical growth rate at which inflation stabilises. Now if you look at what has happened in India since 2008, we had a downturn in investment-to-GDP ratio; we are not at the 38%, but we are at 36.5%.
But if we take that investment and break it down into two parts - one part is structure, infrastructure, housing etc. and the other part is equipment. The one that has actually fallen very sharply is corporate equipment investment.
Just to give you a sense of how much it has declined, back in 2008, it was around 17-18% of GDP, and it is now down to about 13% of GDP and this decline in equipment investment. This concerns us a lot because that also drives productivity growth.
The fact is that corporate India is not bringing in new equipment. Therefore, it is not bringing in the things that actually start pushing productivity growth upwards. The combination of two of them suggests at least the growth is probably closer to 6% than 7.2% that Pronabda talked about. The fact that corporate India has done very little in terms of improving technology, therefore, productivity growth per se has also fallen because of that.
Q: The ICOR (Incremental Capital Output Ratio) that we normally work with is really manufacturing ICOR. Data wise, do we have the wherewithal to be able to project a potential rate of growth? Secondly, in several countries it is also measured through the employment route. That route is practically closed to us because there we have not made much headway in terms of statistical calculation.
Chakrabarrty: There are two broad ways in which one measures the potential output. One is through some kind of a production function approach where you think of employment, capital and productivity. There, the basic issue is that you have a lack of good employment data in India.
You have probably decent capital data, but that capital data comes with a substantial lag of around two years with annual survey of industries. So it's difficult to say that whether on a concurrent basis, there is any decline in potential growth or not. Then there is the issue of productivity. Jahangir's point comes in that productivity itself is a number which probably changes very rapidly over time periods.
But in a crude way, when we measure it through ICOR, we tend to gloss over it and put that 4% number on that productivity/ICOR. That's why our central potential growth argument tends to be just from capital accumulation.
Hence, we say that if there is government dissaving or if there is more foreign inflows then potentially the capital employment is higher and growth will be higher. I think it's a very involved and complex issue of getting the productivity number right. Unless we get that, we will always get a very imprecise estimate of potential growth just arising out of the capital employed.
Q: What would be the other way? Just the historical way - the Hodrick Prescott analysis?
Chakrabarrty: Yes. That's another way of looking at things, which is simply to not look at macro fundamentals but look at GDP growth as a univariate time series and try to employ sophisticated statistical tools to take out the cyclical components, and look at the structural element in that growth process. Unfortunately, in countries like India, which is extremely dynamic and going through rapid structural shifts, those measures, to my mind, are not so appropriate.
Q: What about the binding constraints that we see now? We see them in power very clearly. We see them perhaps in railways. We see them in land acquisitions. Some of these definitely are solvable. We perhaps went ahead in power generation. We have not yet caught up in terms of distribution transmission. We have perhaps not caught up in terms of fuel surprise. But these are not entirely difficult to correct constraints and it's possible that in a three year cycle those constraints will get corrected. So do you think this 7.2% is cast in stone?
Sen: No, it's not cast in stone at all. It's cast in two stones. One is getting a credible fiscal correction. The second is what's happening with the world economy. On the world economy what we are doing is making fairly pessimistic assumptions on the fiscal correction making perhaps somewhat optimistic assumptions. So they are not cast in stone in any sense.
But the main issue in all of this is that again, when we talk about growth processes, productivity certainly is an important element. But there is one element of productivity that I don't think Jahangir is fully taking account that in the services sector, there has been substantial increase in productivity over the last 20 years.
Unfortunately, we don't have the ASI kind of data to be able to do a detailed firm level disaggregation. But for the macro level, the productivity numbers are quite startling. My sense is that even with what has happened over the last couple of years, the productivity growth in the services sector really hasn't gone down at all.
Aziz: As Samiran and Dr. Sen talked about, this is not an issue that is black and white and we can agree on this. This is something that doesn't really exist in the economy. We, as economists or economic journalists, simply make these things up as analytical tools.
Q: It's a little more than that. We need a potential rate of growth in the head. Reserve Bank needs it in its head. Otherwise it will not be able to calculate an output gap, and if it feels that there is an output gap, it will believe that there is a scope for monetary policy. So the Reserve Bank cannot do without a potential rate of growth in its head. It needs to calculate, and therefore, where will you pitch it?
Aziz: I am going to talk about the proof of the pudding. The proof of the pudding is that if indeed this economy is running potential growth of about 7.5%, we have been running sub-7.5% for two straight quarters, we should have seen by now significant amount of slack in the economy. Consequently, we should have seen core inflation in July numbers fall. We haven't seen that. We have seen core inflation rise since May.
May rose 0.3%, June rose 0.8%, July number was up 0.9% on a month-on-month basis. So I am going to come to the proof of the pudding. If indeed we are all wrong and potential GDP in fact is 7.5% as RBI says, we shouldn't really worry about core inflation at all at 5.3% growth rate. We can't have both.
Q: Where do you stand on the July inflation numbers? Do you think that finally we are seeing some kind of a slowing of inflation? Remember, the May inflation number has also not been revised higher. When the June inflation numbers came, we were slightly pleasantly surprised.
Chakrabarty: The July inflation print is one of those prints which will give both the doves and hawks something to talk about. The doves will talk about the headline. The hawks will talk about the core inflation. I am probably in the hawk's camp this time around.
I am not taking this number as a positive surprise. The positive surprise primarily has come in the fuel segment where we have seen Naphta, ATF etc. prices coming down 8-10% in the month. But if you track their global prices, they are up about 10-15% in the month in the global markets. So I am not very sure why this disconnect is coming. I am not sure why vegetable prices particularly cabbages etc. come down so much while potatoes and onions are up. So there seems to be lot of question marks on the food and fuel inflation data.
Q: Dr. Sen, are the numbers convincing you? My sense is there are four or five inflation points. The June inflation definitely was forecast at about 7.41% and it ultimately came in at 7.25%. The revision of the April numbers was not as strong as the revision of the March numbers. The May inflation revision has been zero and then we are getting some kind of a surprise. If we didn't question the previous data, we should question the quality of the data now. So is there some kind of an end to this long and sticky inflation innings?
Sen: From this data, no. Frankly, I have been a hawk for a while, but there is collateral evidence which gives hope; the data on wage formation tends to suggest that there is a moderation of the wage inflation. If that is the case, you should start seeing inflation moderating in the coming months. But that we can only wait and hope.
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