Two Issues in India’s Growth Story

C. Rangarajan*

This article discusses two issues in relation to India’s growth performance. One is on the determination of the potential rate of growth of the Indian economy and the other on the estimation of the threshold level of inflation, the level of inflation beyond which growth turns negative.

Potential Rate

The Indian economy is currently passing through a phase of relatively slow growth. However, this should not cloud the fact that over the eight year period beginning 2005-06, the average annual growth rate has been 8 per cent. Against this background, a frequently asked question is whether India has the potential to grow at a sustained growth rate of 8 to 9 per cent potential rate.

Normally, potential growth is measured using trends and filters like the H-P. In one sense, these are backward looking measures, since they depend on historically observed data. In the case of measuring capacity utilization, the maximum

*Extracted from the Address at the Golden Jubilee of the Indian Econometric Society held on December 22, 2013 at Mumbai.

capacity is very often taken as the maximum output achieved in the recent period. In any case, in the case of determining the potential rate of growth of the economy one can take the maximum growth rate achieved in the recent past as the lowest estimate of the potential. This assumption can be made, if there is reason to believe that the maximum growth rate achieved in the recent past was not an one-off event and the growth rate achieved was robust. India achieved a growth rate of 9.5 per cent in 2005-06 followed by 9.6 per cent and 9.3 per cent in the subsequent two years. After declining a bit in the wake of international financial crisis, growth rate went back to 9.3 per cent in 2010-11. In many ways the growth rate achieved in the high phase period of 2005-06 to 2007-08 was robust. The domestic savings rate during this period averaged 33.4 per cent of GDP. Similarly, the gross capital formation rate averaged 34.2 per cent. The current account deficit remained low with an average of 1.1 per cent of GDP. Agricultural growth during this period averaged 5 per cent and the annual manufacturing growth rate was 11.5 per cent. The capital flows were large but as CAD remained very low, the accretion to reserves amounted to $144 billion. Thus on many dimensions the growth rate was robust. It was not just fuelled by financial availability. Certainly, the external environment provided good support. This was the period during which the world economy was also booming. The growth rate slowed to 6.2 per cent in 2011-12, even though the rate may be revised upwards. It came down to 5 per cent last year and this year it is expected to be around the same level. The savings and investment rates have come down significantly from the peak reached in 2007-08, partly due to economic and partly because of non-economic factors such as perception towards governance and policy framework. Nevertheless, recent data indicate that in 2011-12 the gross fixed capital formation rate, a measure of the accumulation of fixed assets by business, government and households, was around 30.6 per cent as against 32.9 per cent of GDP in 2007-08 (Table 1). In normal conditions, keeping in view the recent trends in ICOR (the Incremental Capital Output Ratio) which is around 4, this should have given us a growth rate of 7 to 7.5 per cent but the actual rate turned out to be 6 per cent. Economic growth has in fact declined much more steeply than what is warranted by the decline in investment. This may be because projects have not been completed in time or complementary investments have not been forthcoming.

Table 1

Savings and Investment Rates

(as a proportion of GDP)

2007-08 / 2011-12 / Change over the period
Gross domestic savings rate / 36.8 / 30.8 / (-) 6.0
Households / 22.4 / 22.3 / (-) 0.1
Financial assets / (11.6) / (8.0) / (-) 3.6
Private corporate / 9.4 / 7.2 / (-) 2.2
Public sector / 5.0 / 1.3 / (-) 3.7
Gross Capital Formation / 38.0 / 35.4 / (-) 2.6
Public sector / 8.9 / 7.9 / (-) 1.0
Private corporate / 17.3 / 10.6 / (-) 6.7
Households / 10.8 / 14.3 / (+) 3.5
Valuables / 1.1 / 2.7 / (+) 1.6
Gross Fixed Capital Formation / 32.9 / 30.6 / 2.3
Public sector / 8.0 / 7.4 / (-) 0.6
Private corporate / 14.3 / 9.7 / (-) 4.6
Households / 10.6 / 13.6 / (+) 3.0

In some cases, this could also be due to non-availability of critical inputs such as coal and power. The fact that even today, savings and investment rates are at high levels re-assures us that if we are able to find ways to complete projects speedily, we shall be able to usher in rapid growth in income even in the short run. It is, however, to be noted that while the decline in overall gross fixed capital formation rate from the peak reached in 2007-08 was only 2.2 per cent, the decline in the case of private corporate sector was as high as 4.6 per cent. Thus the composition of investment has also played a role in the reduction in productivity of capital. Nevertheless, while the existing level of investment rate should enable us to grow at 7.5 per cent in the short run, a return to higher level of savings and investment can take us back to the very high levels of growth which we had seen earlier.

To assess whether we will be able to get back to the high savings and investment rates of the previous period, we need to look a little more closely at some of the macro economic parameters during the low growth phase. The gross domestic savings rate fell by 6 percentage points between 2007-08 and 2011-12. However, the decline in the investment rate was less. It fell from 38.1 per cent in 2008-09 to 35 per cent in 2011-12 which is a decline of 3 percentage points. The lower decline in the investment rate is accounted for by the fact that the current account deficit rose from 2 per cent of GDP in 2007-08 to 4.2 per cent in 2011-12. Looking at the domestic savings rate, of the decline of 6 percentage points more than half was contributed by the decline in public sector savings. During this period, the fiscal deficit rose sharply. Within household savings, there was a sharp decline in the ratio of savings in financial assets to GDP by 3.6 percentage points, mostly due to high inflation. Going ahead, we should build in only a more modest current account deficit of about 2.5 per cent of GDP. Several studies have shown that this is the only sustainable level of CAD taking into account the normal capital flows. In fact, even a somewhat lower level of CAD will be desirable. Thus to get back to anything like 8.5 per cent growth rate, there has to be some pick up in the domestic savings rate from the current level. For this to happen what is needed is fiscal consolidation. Thus with a modest current account deficit of 2.5 per cent of GDP and a savings rate of 32 per cent of GDP, one can expect the Indian economy to grow at 8.5 per cent. Thus to sustain a long term growth rate of 8.5 per cent, three things need to happen: (1) CAD must be lowered, (2) the domestic savings rate must pick up with much of it coming from fiscal consolidation, and (3) the productivity of capital should improve so that incremental capital output ratio is maintained around 4:1. Given the performance of the Indian economy in the recent past, these are not impossible tasks. But this will require focussed efforts on all the three fronts. Besides, we need to keep a watch on inflation which also has a bearing on the potential rate of growth when it exceeds a threshold level.

Threshold Level of Inflation

During the last three years not only has growth slowed down but inflation has been on the rise. Inflation as measured by the wholesale price index stood at 10.9 per cent in April 2010, 9.7 per cent in April 2011 and 7.5 per cent in April 2012. As of April 2013, it came down to 4.8 per cent. However, there has been a pick up in inflation since then. As of November, it has come to 7.5 per cent. It is, in this context, a question has been raised as to the acceptable or threshold level of inflation. The threshold level of inflation is that level of inflation beyond which inflation has a decisive negative impact on growth.

A case for low and stable inflation has been persuasively made in the literature. The volatility of prices creates uncertainties in decision making. Rising prices adversely affect savings while they make speculative investments more attractive. These apart, there is a crucial social dimension particularly in developing economies. High inflation adversely affects those who have no hedge against it and that includes all the poorer sections of the community. This is indeed a very strong argument in favour of maintenance of low inflation and price stability in emerging economies.

Empirical evidence on the relationship between growth and inflation in a cross country framework is somewhat inconclusive because such studies include countries with an inflation rate as low as 1 to 2 per cent to those with inflation rate going beyond 200 to 300 per cent. These studies, however, clearly establish that growth rates become increasingly weaker at higher rates of inflation. However, in recent years, studies have been done to test the inflation-growth trade off by using each country’s time series data. There are two methods which are adopted. The first one is to regress the annual GDP growth on fundamental factors such as investment, coupled with inflation and square of inflation. The estimated equation is applied for different levels of inflation to find out inflection point or threshold beyond which inflation has negative impact on GDP. The alternative method uses apart from fundamental factors such as investment two variables related to inflation. One variable is the level of inflation and the other a dummy variable which takes on the value of 0 or 1 for different levels of inflation. Threshold level is that level of inflation which minimizes the residual sum of squares of the regression equation. At that level, inflation has a significant negative impact on growth. Using the observations for the period 1982 to 2009, under the first method of estimation, the point of inflection occurs at 6.3 per cent. Under the second method also, the threshold level of inflation seems to fall between 6 and 7 per cent (see Annexure 1). However, when it comes to the acceptable level of inflation for policy guidance, we need to work with a lower level of inflation for two reasons. First, the estimate of trade-off does not take into account the distributional implications of inflation. Second, this level of inflation is way above what other countries have treated as acceptable level of inflation. This will have implications for the exchange rate. While open economy helps to overcome domestic supply shocks, it also imposes the burden to keep the inflation rate in alignment with other countries.

Annexure 1

Estimating the threshold level of Inflation[*]

To estimate the non-linear relationship between inflation and growth two methods have been adopted.**

Method 1

Here we used a model, where the inflation itself captures the non-linearity. The annual GDP growth is regressed on Inflation, square of inflation and growth in Gross Domestic Capital Formation (GDCF).

The estimated equation is applied for different levels of inflation to find out the inflection point,or threshold, beyond which inflation has a negative impact on GDP growth

Using the data for the period 1982 to 2009, the following equation was estimated

Based on the equation the following relationship between growth and inflation is derived

The point of inflection occurs at an inflation of 6.3 per cent.

Method 2

The method developed by Khan and Senhadji (2001) (by using GDP growth as endogenous variable and inflation and Growth of Gross Domestic Capital Formation as exogenous variables) is used to estimate the threshold level of inflation.

The equation estimated is of the following form

Where is aDummy variable defined as,

=

0, other wise

The parameter k helps to determine the threshold inflation level. In the estimated relationship captures the impact of the inflation on growth, explains the impact of inflation exceeding threshold on growth. At the threshold level of inflation, not only both and should be statistically significant but also that should be positive, should be negative and sum of two coefficients,, should be negative and statistically significant. While the value of k is given arbitrarily for the estimation, the optimal k is obtained by finding that value of k that minimizes the residual sum of squares (RSS). Thus, the threshold level is that which minimizes the residual sum of square (RSS). Inflation at this level has a significant negative impact on economic growth.

Estimated equation for the period 1982 to 2010

The sign of become negative when k crosses 6 per cent and reach the least Residual Sum of Squares at optimum when k=7.0 per cent. Therefore we can conclude that the threshold level of inflation for this period was between 6% and 7%.

References

Khan, Mohsin and A S Senhadji (2001), “Threshold Effects in the Relationship between Inflation and Growth”, IMF Staff papers, Vol 48, No 1

Pattaniak, Sitikantha and Nadhanael G V (2011),“Why Persistent High Inflation Impedes Growth? An Empirical Assessment ofThreshold Level of Inflation for India”, RBI Working Paper Series, W P S (DEPR) 17/2011

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[*] I am grateful to Shri. Vibeesh E M for his help in estimating the equations.

** Both the models presented here suffer from one limitation. They do not take into account explicitly the impact of inflation on variables such as exchange rate and income distribution.