The issue of overheating in the Indian context was first raised by the central bank in its 31 October 2006 policy, where it defined an overheating economy as one that “is growing so rapidly that its productive capacity cannot keep pace with resulting demand pressures”. While noting that potential output in India is difficult to ascertain given the underemployment of resources and the current structural transformation in the economy, its stance on overheating turned amber in December—when inflation, as measured by the wholesale price index, crossed its comfort level of 5.5%.
In a bid to control inflation and absorb foreign exchange flows, the Reserve Bank of India (RBI) raised repo rates five times in the last nine months and resorted to using the cash reserve ratio (CRR), hiking it by 150 basis points to 6.5%. While leaving all rates unchanged in its latest policy, it has lowered the medium-term inflation target to 4-4.5%, thus leaving room for one more hike.
Symptoms such as inflation, current account deficit, higher asset prices, wage pressures and infrastructure bottlenecks are an indication that, in the near term, India’s pace of growth is hitting a speed limit.
However, the good news for India is that continued economic reforms and investments may, over time, ease overstretched resource constraints. This should help lift India’s growth potential to 10% in the near future, just as it successfully lifted its growth potential from 4.5% in the 1980s to 6% in the 1990s and 8% levels currently. Faster growth during 1993-2004 was mainly attributable to two important factors—more rapid accumulation of physical capital stocks (growth at 1.8% in 1993-2004 compared with 1% in 1978-93) and stronger total factor productivity growth (2.3% compared with 1.1% previously).
Conceptually, overheating and growth potential are two closely related terms. Growth potential refers to the pace of sustainable growth without causing persistent inflationary pressures. And if actual growth exceeds the potential, the economy exhibits symptoms of overheating high inflation, asset price bubbles and a shortage of resource supplies. However, the growth potential may shift higher over time if resource constraints are eased via policy reforms and investments bridge capacity constraints. Thus, despite symptoms of overheating, we firmly believe that the Indian economy is moving toward higher levels of growth potential, perhaps around 10%. But in order for India to climb to a higher level of growth potential, it needs to make a substantial policy effort to remove the remaining barriers to ensure faster growth of production factors (labour, skills/education, capital, land) as well as productivity.
While strong investment demand is an important contributing factor to today’s overheating problem, ongoing investments—both in corporate capital expenditure as well as infrastructure—will eventually raise supply capacities and ease bottlenecks. But clearly, more needs to be done and at a quicker pace.
The rise in labour costs, especially those of unskilled labour, appears odd, given India’s abundant labour force. The reason, perhaps, lies in labour market rigidities, yet another barrier for India’s move to a higher growth potential. The Chinese experience suggests that migration of farmers to non-agricultural activities, through development of labour-intensive urban sectors, was a key contributor to the extraordinary 4% total factor productivity gain during the past 30 years. While a rapid increase in the cost of skilled labour in India is less surprising and points to the potential limit of the current growth model, the government and the corporate sector have been making efforts in easing this constraint, though admittedly the accumulation of skills takes time.
While market-oriented reforms and an open-door policy were key reasons for India’s ascendancy in the world economy during the past decade or two, to move the economy to the next level of growth, further reforms to promote productivity growth are necessary. These include better macroeconomic management and greater reduction of transaction costs for businesses and investors.
While leaving rates unchanged in the recent policy, but lowering its inflation tolerance, we expect RBI to implement one more rate hike in the coming months. We believe that RBI is likely caught in the trap of the ‘impossible trinity’, given its attempts to have an independent monetary policy simultaneously targeting exchange rates, with a partially-open capital account. It has possibly finally reconciled to an appreciating rupee which, in turn, would reduce sterilization, giving it greater freedom to target money supply, credit growth and inflation. However, on the positive side, RBI has also taken several prudent measures in raising risk weights and tightening norms in areas of high growth, such as real estate and housing.
Rohini Malkani is India economist for Citi.