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Photo: Reuters  (Reuters)
Photo: Reuters (Reuters)

India’s potential growth rate below 7%: RBI paper

Growth below potential now, leaving room for more monetary easing, but output gap is closing, says paper

Mumbai: What is the potential growth rate of the Indian economy? The question, the answer to which is key to policy decisions such as how far interest rates should be lowered, has always been an actively debated one. The latest estimate of the country’s potential growth rate comes from a working paper released by the Reserve Bank of India (RBI) on Thursday that pegs it at below 7%, having decelerated from levels of around 8% in 2003-08.

India’s potential growth for the most recent period is about 6.8%, with a band of (+/-) 50 basis points (bps), found a working paper authored by Barendra Kumar Bhoi and Harendra Kumar Behera from RBI’s monetary policy department. A basis point is one-hundredth of a percentage point.

“Potential growth had increased steadily from its low level of around 5% in 1980s to about 6% during 1992-2002 and accelerated to around 8% during 2003-2008," said the paper, adding that potential growth fell significantly in the post-global crisis period to around 7% in the years between 2009 and 2015.

Potential output generally refers to the level of output that is consistent with full capacity utilization along with low and stable inflation. An assessment of the potential output is used to assess what is known as the output gap—the difference between actual output and potential output. When this gap is negative, the economy is considered to be growing below potential, leaving scope for monetary easing. A positive output gap, in contrast, can lead to inflationary pressures as demand exceeds supply.

According to the working paper, while the output gap in India has been negative since the third quarter of 2012, the gap is “slowly closing". This suggests that RBI is not relying on GDP growth estimates under the new series, which pegs growth for fiscal 2016 at 7.6%.

If growth under the new series was to be compared to the potential output as determined by the paper, the output gap in India would be positive, leaving little room for rate reductions.

“Since the paper finds that the output gap is still negative, although closing, there is still scope for monetary policy to remain accommodative," said Shubhada Rao, chief economist at Yes Bank Ltd, adding that the assessment of the output gap suggests RBI is not relying on GDP data under the new series.

Even so, the assessment that the output gap is closing could mean that RBI does not have much more room left to reduce interest rates. The central bank has cut rates by 150 bps since the start of 2015 in response to easing inflation and sluggish growth indicators. While RBI has maintained an accommodative stance, it has said that further rate decisions would depend on incoming data, particularly on the trajectory of inflation.

Consumer Price Index (CPI)-based inflation fell to a six-month low of 4.83% in March. A good monsoon is expected to help keep inflation pressures in check and allow room for an additional 25-50 bps in rate cuts during the current fiscal year.

Potential output, of course, is not a static number and changes based on structural changes in the economy.

According to the working paper, capital formation is a key driver for potential output, which highlights the need for investment-led growth in the economy.

“Key to accelerate growth as well as potential output in India lies with higher level of capital formation as its contribution dominates vis-à-vis the contribution of labour and the total factor productivity," said the authors of the paper.

Rao of Yes Bank said this only reiterates the need to push up investment in the economy.

“It is imperative for the economy to have investment-led growth and since the most recent CMIE (Center For Monitoring Indian Economy) data suggests that private sector investment remains weak, the onus would fall on government-led investment," Rao said, adding that as long as growth is “supply-augmenting", RBI can justify maintaining an accommodative monetary policy stance.

The views expressed in the working paper do not necessarily reflect the views of the central bank.

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