Home / Opinion / Online Views /  The Indian economy’s new normal

A growing number of economists are warning that the flight path of the Indian economy in the coming years will be far lower than its soaring trajectory in the boom years. This shift will have important implication in areas such as interest rate policy, corporate earnings, consumer demand, asset prices, job creation, tax revenue and energy needs.

JP Morgan economists Jahangir Aziz and Sajjid Chinoy said in a 7 September note that the persistence of high inflation despite falling growth is because the potential growth rate of the Indian economy has fallen to 6-6.5%, lower than the 7.5% assumed by policy makers and the financial markets. Reserve Bank of India governor D. Subbarao has said earlier that the potential growth rate of the Indian economy --- or the growth it can sustain without setting off an inflationary fire --- is 7.5%, a full percentage point lower than the pre-2008 levels.

Other emerging market economies could also be facing the same problem. In an interview with the Wall Street Journal soon after he stepped down as chief economist of the International Monetary Fund, Olivier Blanchard more than hinted that the glory days were over: “Emerging market countries had a great decade and it may well be that their potential growth rate is really lower than the actual growth rate was, and maybe even their potential growth rate was before."

UBS economist George Magnus has asked in a report released this month whether the Asian miracle is over. India is of special concern. “In India, the rethinking about trend growth is even more trenchant… Only a few years ago, popular thinking was that India would be the next 10% growth story, but, as things stand, it may be more realistic to think of India’s underlying growth as closer to 5-6%," writes Magnus.

The Indian government continues to bet on a growth rebound. The Planning Commission could, according to newspaper reports, reduce its target growth rate for the 12th Five Year Plan (2012-17) from the earlier 9% to 8.2%, but that is still far more than what many other economists are estimating is possible in the current circumstances. The plan panel is to meet later this month to decide.

There are several statistical techniques used by economists to assess how fast an economy can grow. One set of techniques uses filters to remove cyclical fluctuations from data in order to get a sense of the underlying trend. Another way is to deduce the growth rate by dividing the investment rate by the efficiency of capital use; in the Indian case, a fall in the investment rate as well as deterioration in efficiency has likely pulled down the potential growth rate. A third option is to use a production function to estimate how much can be produced with a given set of physical capital, human capital, efficiency and innovation.

The most immediate impact of a lower potential growth rate will be on monetary policy. One important parameter tracked by central banks is the output gap, or the difference between the actual and potential growth rates. The output gap is also an important input into the Taylor Rule, used by central bankers to estimate policy rates.

Despite the recent slowdown, the output gap in India is not as wide as many assume, which means that the case for large interest-rate cuts is far weaker than many feel. It is also the reason why inflation continues to remain at high levels.

Getting out of the trap of lower growth will require fiscal discipline as well as policy reforms, say economists. “If… policymaking continues to dither, India’s growth potential will remain depressed, leading to a sustained period of slow growth and elevated inflation," warn Aziz and Chinoy.

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