The splendid rebound in economic growth over the past few quarters has once again raised hopes that the Indian economy is back on the fast track for good. The Economic Survey released in February alluded to the possibility that India could grow at double digits in the coming decade. Such optimism is rampant in the private sector as well. Participants in a discussion on financial markets that was hosted by this newspaper in Mumbai last week were uniformly bullish about our economic prospects.
There is good reason to believe that double-digit growth is within our reach. The coming 10 years could see India in a demographic sweet spot, when the proportion of our population in the working age groups grows while the dependency ratio drops. The global experience is that savings and investment rates reach their peaks at such moments of demographic transition. Growth accelerates.
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Our current savings rate is around 35% of gross domestic product (GDP), a sharp increase of more than 10 percentage points from the savings rate we were accustomed to in the last 25 years of the previous century. The savings rate is likely to continue going up in the current decade as incomes increase and the working population bulges. A back-of-the-envelope calculation suggests that India could very well grow in double digits on a sustained basis, if the domestic savings rate crosses 40% of GDP in the coming years, assuming that the government does not keep running up huge revenue deficits.
That’s the incontrovertible good news. But decision makers in the government and the private sector will have to face up to an uncomfortable fact: India has revealed the tendency to quickly overheat whenever economic growth moves beyond 8.5% for a few successive quarters. We saw that in 2007 and we see it in 2010. Consumer prices begin to climb, real estate becomes pricey and equities start looking expensive.
Just look at the inflation numbers right now. India has had double-digit wholesale price inflation since February and growth in prices of manufactured goods has shot up from close to zero in November to 7.3% in June, as the inflation virus moved beyond food and infected the rest of the economy as well. The influential council of economists that advises the Prime Minister has said in its most recent report that inflation is at least double of what it should be.
Indian inflation has accelerated at a time when most developed countries are struggling with the prospect of deflation, so it is hard to argue that our inflation has been imported from other countries (as it could have been argued in 2007). The macroeconomic review published by the Reserve Bank of India in July shows that consumer price inflation is almost twice the level in other developing countries. The Consumer Price Index for Industrial Workers (CPI-IW) in June was 13.9% above the level a year ago. The next highest inflation among major developing nations is Russia, with 5.8%. China’s CPI inflation a modest 2.9%.
In short, the Indian economy seems to overheat very early in the business cycle. This is a structural weakness that needs to be addressed, even if it spoils a few celebratory parties.
Why is this so? Over the past week, I put this question to several experts. A hedge fund manager who is based in Singapore told me that our tendency to prematurely overheat is linked to the inability of the Indian economy to absorb domestic and foreign investment flows. At the end of the Sixth New India Lecture, sponsored by the New India Foundation and Mint, and delivered by Raghuram Rajan of the University of Chicago, an economist told me that the root of this problem lay in the infrastructure bottlenecks and land market rigidities that continue to hold back the Indian economy. An entrepreneur from the education and training sector offered the explanation that lack of skilled labour puts pressure on wage costs and later the prices of goods and services. I guess that yet another problem is the unfortunate tendency of the Indian government to run pro-cyclical fiscal policies, which pump effective demand when it is already running strong because of private sector consumption and investment.
These are initial conjectures. More thought needs to be given to the question of what India’s non-inflationary growth path is. Economist Arvind Subramanian, in his Business Standard column on the inflation puzzle, offered a sobering possibility: “… there is cause for worry because the implication is that the economy’s current growth rate of 7-8% is above its potential or trend growth rate. In this view, and unless capacity can be significantly increased, attaining China-type double-digit growth rates will remain elusive.”
That’s a cold splash of reality in the face of a nation that assumes that double-digit growth is now a certainty.
Niranjan Rajadhyaksha is managing editor of Mint. Your comments are welcome at firstname.lastname@example.org