How to India Grow at 8.5%

 by Mr. C. Rangarajan, Prime Ministers Economic Advisory Council

Lower CAD, higher savings rate and better capital productivity can again lead to high growth

The Indian economy is currently passing through a phase of relatively slow growth, but this should not cloud the fact that over the eight-year period beginning 2005-06, the average annual growth rate has been 8 %. Does India have the potential to grow at a sustained rate of 8-9 % Normally, potential growth is measured using trends.

These are backward-looking measures, since they depend on historically observed data.

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, if there is reason to believe that the maximum growth rate achieved in the recent past was not a one-off event and the growth rate achieved was robust. India achieved a growth rate of 9.5 % in 2005-06, followed by 9.6 % and 9.3 % in the subsequent 2 years.

Reverse Swing..

After declining a bit in the wake of the international financial crisis,growth rate went back to 9.3 % in 2010-11. The growth rate achieved during 2005-06 to 2007-08 was robust. The domestic savings rate during this period averaged 33.4 % of GDP. Similarly,the gross capital formation rate averaged 34.2 %. The current account deficit remained low with an average of 1.1 % of GDP.

Farm growth during this period averaged 5 % and the annual manufacturing growth rate was 11.5 %. The capital flows were large but as the current account deficit remained very low,the accretion to reserves amounted to $144 billion.

On many dimensions, the growth rate was robust. It was not just fuelled by financial availability. This was the period during which the world economy was also booming. The growth rate slowed to 6.2 % in 2011-12, though this rate may be revised upwards. It came down to 5 % last year and this year,it is expected to be around the same level.

Mr. C. Rangarajan

Growth Mismatch..

The savings & investment rates have come down from the peak reached in 2007-08, because of economic and non-economic factors like perceptions about governance & policy. Nevertheless, recent data indicates 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 % against 32.9 % of GDP in 2007-08.

In normal conditions, this should have given us a growth rate of 7 % to 7.5 %,but the actual rate turned out to be 6 %. Growth has 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. Or, it could also be due to non-availability of inputs such as coal and power. But, savings and investment rates are at high levels, so if we are able to find ways to complete projects speedily, growth will follow in the short run.

But, while the decline in overall gross fixed capital formation from the peak reached in 2007-08 was only 2.2 %, the decline for the private corporate sector was as high as 4.6 %. The composition of investment has also played a role in the reduction in productivity of capital. While the existing level of investment rate should enable us to grow at 7.5 % in the short run, a return to higher savings &  investment can take us back to very high levels of growth.

To assess whether we will be able to get back to high savings and investment rates,we need to look a little more closely at some macro parameters during the low-growth phase.

Fall Season..

The gross domestic savings rate fell by 6% points between 2007-08 and 2011-12, but the fall in the investment rate was around 3% points. The lower decline is because the current account deficit rose from 2 % of GDP in 2007-08 to 4.2 % in 2011-12.

Of the decline of 6% points in domestic savings, more than half was contributed by a fall 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% points, mostly due to high inflation.

We forecast a more modest current account deficit of nearly 2.5 % of GDP. Even a somewhat lower level of current account deficit will be desirable. To get back to 8.5 % growth,domestic savings have to pick up.

For that, we need fiscal consolidation. So, with a modest current account deficit of 2.5 % of GDP and a savings rate of 32 % of GDP, one can expect the Indian economy to grow at 8.5 %.

To sustain a long-term growth rate of 8.5 %, three things need to happen: the current account deficit must be lowered, the domestic savings rate must pick up, with much of it coming from fiscal consolidation, and the productivity of capital should improve. These are not impossible tasks, but will require focused efforts on all the three fronts.

About the author..

The writer is C Rangarajan, Chairman, Prime Ministers Economic Advisory Council

Share: