Understanding the amazing GDP growth

Business Standard, 4 October 2006

The first quarter 2006 GDP growth figure of 8.9 percent has surpassed all forecasts. It was the 12th consecutive quarter in this streak of marvellous high growth in India, which began from the Jun-Sep 2003 quarter. In this three-year period, the mean and median of growth was roughly 8.4%, and all 12 values of growth rates are tightly clustered around each other. Three years at 8.4% GDP growth in India have never happened before.

Some people believe that India has moved up to trend GDP growth of 8.5%. I believe this is not the case; that average GDP growth in the next 12 quarters will come out significantly below this remarkable performance.

Trend GDP growth has slowly accelerated from 3.5% to 6.5% over the 1979 to 2006 period. This has reflected a combination of economic reforms, a higher investment rate, and the "demographic dividend" from a bigger workforce.

Layered on top of this slowly accelerating trend is a business cycle. This is a new phenomenon, which was not found when India was a socialist country, and one which has been a key feature of Indian macroeconomics from the mid 1990s onwards. We had a low of the business cycle in 2001-02, which was followed by a high of the business cycle which we are presently in. The 12 quarters of 8.5% growth reflect a combination of trend growth at 6.5% with an extra two percentage points owing to favourable business cycle conditions.

Four factors have been at work accentuating this high of the business cycle:

  1. We have a procyclical (destabilising) monetary policy. Smoothed CPI inflation has risen from 3% in 2004 to 6.5% today - an acceleration of 350 basis points. Policy rates of the RBI have not commensurately risen, thus violating a key requirement of a stabilising monetary policy. Inflation rose but the short rate did not rise, so real rates went down - which has been expansionary. Expansionary shocks are getting accentuated by expansionary monetary policy.
  2. We have a procyclical fiscal policy. While working within the game plan of the FRBM, what has been happening is that when tax revenues are buoyant, every minister dreams up more spending programs. When tax revenues are weak, cabinet is frugal. This is a procyclical and destabilising fiscal policy, one which accentuates good times.
  3. There has been torrid expansion of non-food credit, which has grown at a trend rate of 26.4% over the last five years. This high growth partly reflects the fact that when times are good, fewer NPAs surface, so banks feel there is space for more lending. When times are good, banks accentuate them by lending more. Conversely, when times are bad, and NPAs start surfacing, banks will be short of equity capital and pull back from lending, which will exacerbate the down of the business cycle.
  4. Finally, we have been helped by powerful world GDP growth. The world economy grew at 5.3 and 4.9 percent in 2004 and 2005 - it is not that exceptional for India to be doing 8.5% at such a time.

What can we see in peering into the next 12 quarters, i.e. from Jun-Sep 2006 till Apr-Jun 2009? Many things are likely to go wrong.

External conditions will be less benign. The IMF World Economic Outlook offers the following projections. The US will slow down from 3.4 percent in 2006 to 2.9 percent in 2007. The euro area will slow down from 2.4 percent to 2 percent. Japan will slow down from 2.7 percent to 2.1 percent. These projections are based on the institutional view, which the IMF is obliged to uphold, that global macroeconomic imbalances will unwind in a graceful way. If the unwinding of global macroeconomic imbalances takes place in an ungraceful way, a possibility which many top economists take quite seriously, then world GDP growth will have a sharper decline.

In most countries of the world, politicians seek to accomodate inflation while central banks are hawkish about it. In India, we may have it upside down, with a political system that has very low inflation tolerance, and a monetary regime which consists of a pegged exchange rate, that is less concerned about inflation. But even if RBI is comfortable with 6.5% inflation, politicians are likely to yearn for a return to 3% inflation. This will translate into pressures for tight monetary policy, particularly as the next general elections approach. Economists such as myself would applaud if the government takes the task of returning to 3% inflation very seriously.

The political and fiscal climate are likely to be stressful, given the "triple-witching" of impending general elections, the FRBM objectives, and the 6th pay commission, all of which will come together in the next 12 quarters.

Once a turning point of the business cycle is reached, the three procyclical forces - destabilising monetary policy, destabilising fiscal policy and destabilising bank credit - would come into play to accentuate the downturn just as they have worked to accentuate the high of the business cycle in recent years.

There is nothing India needs more than an acceleration of the trend GDP growth rate to 10%. The recent 12 quarters should not make us complacent about what has been achieved. This complacence has accentuated the unfavourable political climate for economic reforms. High GDP growth and a benign fiscal situation should be seen as a temporary opportunity, one which should be harnessed to make political deals so that economic reforms are achieved, and trend GDP growth is accelerated. When there is a downturn, it will be harder to make such deals.

One element of the economic reforms program that is needed is an examination of fiscal policy, monetary policy and banking regulation, seeking to address the problem of their being destabilising (i.e. procyclical). This would reduce the extent to which India suffers from these patterns of boom and bust. Sound fiscal institutions and sound banking regulation can reduce the extent to which these two elements are destabilising. The big opportunity is with monetary policy. Instead of doing harm by being destabilising, as is the case today, it can be the mainstay of countercyclical macroeconomic policy, as is the case in all mature market economies. This requires the creation of a monetary authority with the narrow mandate of achieving an inflation target.

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