An inflated growth number

An inflated growth number

The budget and later pronouncements by finance minister Pranab Mukherjee and officials have pegged India’s growth rate for 2011-12 at 9% (plus or minus 0.25%). In the month since the budget was passed, there have been few, if any, answers to these lingering questions behind that number.

To cite one such doubt: what are the inflation assumptions behind that level of gross domestic product (GDP) growth? India’s potential GDP has been variously estimated to be around 8-8.25%. The 9% number is clearly above that. If anything, potential GDP has stayed where it was for a while, while real GDP has been rising. That leads to the question that what is being done to reduce the output gap. For this gap to be reduced, sustained investment in capacity expansion over at least two to three quarters is called for. Given the recent slowing in investment demand, it is not clear how this can be done quickly.

Then, there is the issue of the impact of the fiscal correction on growth. Since 2008, the fiscal stimulus by the government has contributed a big helping hand to growth. In 2011-12, Mukherjee has planned what is perhaps the single biggest fiscal correction likely to be seen in Indian history: from a fiscal deficit of 6.7% (excluding sales of one-off items) to 4.6% of GDP. Can the government be so sanguine that it will have no impact on growth? One implicit assumption is that this will lead to, so to speak, a “crowding in" effect on the part of the private sector and that expected pick-up in investment will sort out part of the problem. This remains to be seen. If anything, private sector economists feel this has the potential to shave off 1-1.2% of GDP. While that may be an overtly pessimistic forecast, there certainly will be a hit to growth from a fiscal correction of this scale.

A neat way to arrive at a 9% growth figure is to assume a 36% investment with an incremental capital output ratio (ICOR)—the ratio of investment to growth. (The higher the ICOR, the lower the productivity of capital)—of 4, leading to a growth rate of 9%. As said before, it is a neat way to look at the situation. This, however, ignores messy complications that are likely to emerge due to fiscal correction and the inability to narrow the output gap. It is difficult to believe that a country like India, with manifold supply constraints, can have 9% growth with 7% inflation at the same time.

High growth and low inflation in India: Dream or reality? Tell us at