The Indian Economy Blog

November 29, 2006

Sizzling, Or Just Right?

Filed under: Business — Edward @ 11:18 pm

Earlier in the week Naveen drew our attention to a recent article in the Economist, Too hot to handle: Why the sizzling Indian economy is more at risk than China’s?. Now the article is an interesting one, but it does revisit a theme which we have already discussed a number of times on this blog, namely just how high is trend growth in India?

Ajay Shah sums the issue up nicely:

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.

That is growth in an economy is the product of a demographic dividend (or penalty) factor (which may of course be neutral), an economic reforms component and a demand component (whether this comes from investment or consumption). His guess is that trend growth is around 6.5% and he does not consider that the rather higher growth numbers we have seen of late are sustainable:

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.

Well I just happen to be one of those people Ajay is talking about: I am even  brazen enough to believe that trend growth may well have moved up beyond 8.5% going forward, and that indeed within 5 years we may well see India overtaking China in terms of average quarterly growth rates (of course this may well vary from one quarter to another, a phenomenon known as volatility, and of course 5 years from now the Chinese economy may not still be sustaining the very high growth rates we see today).

But obviously Ajay is not alone in taking the view he does, the Economist, by and large, agrees with him:

India’s trend growth rate has almost certainly increased but it is still nowhere near as high as China’s. Mr Prior-Wandesforde estimates that it is now around 6.5%, up from 5% in the late 1980s. But India’s recent acceleration largely reflects a cyclical boom, thanks to loose monetary and fiscal policy. The Reserve Bank of India has raised one of its key interest rates by one and a half percentage points to 6% over the past two years, but inflation has risen by more, so real interest rates have fallen and are historically low. This makes the economy more vulnerable to a hard landing.

India cannot grow as fast as China without igniting inflation because of its lower investment rate, particularly in infrastructure, and labour bottlenecks.

Now just one small point on this before I get more into the substantive issue, the Economist really does need to make up its mind what it is advocating, since this rather unfavourable investment comparison with China does rather conflict with earlier opinions they were voicing about the unsustainability of the investment/export driven model China seems to have, and how India was more balanced given the key role of domestic consumption, but let’s leave that on one side for the moment.

Neither am I, of course, alone in thinking India’s trend growth rate may be considerably higher than many imagine it to be. Surjit Bhalla, for example, seems to hold a somewhat similar view:

Some, however, believe that an investment boom is under way. A recent report by Surjit Bhalla of Oxus Investments, an economic research firm and hedge fund, has caused a stir by estimating that investment in the year ending in March 2007 will reach between 38% and 42% of GDP. Such investment, he says, would allow India to sustain 10% annual GDP growth.

The Economist will of course have none of this:
Sadly, Mr Bhalla’s estimate for investment is almost certainly too high. Unless saving (29% of GDP in 2004-05) has also surged over the past two years, an investment rate of 40% would imply a current-account deficit (which must equal the gap between saving and investment) of close to 10% of GDP. This does not square with trade figures and, in any case, it would hardly be a sign of economic health. Nor does a significant increase in saving look likely given strong consumer spending this year and only a modest fall in the government’s budget deficit.

Curiously though what Surjit is saying does rather fit in with what we talked about on this post here (which examined the state of play as far as potential for infrastructure investment in India goes).

And as it happens Bloomberg today have an article on the same topic in anticipation of the latest quarterly GDP numbers expected tomorrow:

India’s $775 billion economy has grown more than 8 percent in five of the past six quarters. China’s $2.2 trillion economy, Asia’s second largest, expanded 10.4 percent in the quarter ended Sept. 30, the quickest pace among the world’s 20 largest economies and almost four times the 2.6 percent gain in the 12 European nations sharing the euro….

General Motors Corp., Royal Dutch Shell Plc. and other companies have invested in about 3,000 new factories and expansion projects worth about $21 billion in India since May 2004 to cater to growing demand, according to Finance Minister Palaniappan Chidambaram.

“India’s high growth trajectory is here to stay,” said Brijmohan Lall Munjal, chairman of Hero Honda Motors Ltd., India’s biggest motorcycle maker, currently building its third factory for $420 million. “Incomes are rising, the government is spending more money to improve infrastructure. Economic growth will only get stronger from here.”

The creation of new jobs in the software industry and at call centers is putting more money in the hands of some 350 million middle-class Indians. For example, Dell Inc., the world’s second-largest personal-computer maker, opened its fourth customer-service center in India this month as it seeks to reduce costs to shore up declining profit.

Growth in India’s economy is also benefiting from Prime Minister Manmohan Singh’s decision to increase spending on roads, ports and other infrastructure by a quarter to 992 billion rupees ($22 billion) in the year that started April 1 in a bid to attract overseas manufacturing companies and spur growth to 10 percent over a decade.

Infrastructure spending is spurring demand for steel, cement and electricity in India, which spends a seventh of China’s $150 billion investment in public works each year according to Morgan Stanley.

So what we seem to have here is a win-win type cycle where an initial increase in domestic consumption  (fueled to some extent by the outsourcing boom) is now moving over to an investment driven infrastructural and industrialization one. Not that this is going by any means to be an easy process to manage, but the potential for very high growth rates is there, and that, at the end of the day, is what this debate is all about. Of course India needs more efficient capital markets, of course she needs labour market flexibilization, of course the regulatory infrastructure needs to be improved, but this isn’t the point. The argument here is, even in the absence of all of this in the short term how fast can India grow, and my feeling is that it can grow a lot faster than the Economist seems to think.  My reasoning? I tend  to give a lot higher weighting to the demographic component than most other commentators seem willing to do, and I also think that conventional analysis often ignores the speed with which behavioural change spreads (and this at the end of the day is an important part of the productivity picture) in an age of mobile phones and internet connectedness (which is another way of saying that we should expect ‘convergence’ to be much more rapid today than it was in the past.

So who is right and who is wrong here? Well the data will tell us, now won’t it, and the first little test will come tomorrow, when we should get to know just what third quarter GDP growth has actually looked like.

14 Comments »

  1. I think the core diff b/t the 2 economies sorta boils down to this

    DEMAND SIDE
    - India is internal
    - China is external

    SUPPLY SIDE
    - India is constrained by infra
    - China is using political control to build massive infra

    the problem that results is that even though you might have equiv aggregate demand growth, India faces supply side constraints which create the inflationary fears (e.g. instead of buying more cars / trucks / consumer goods / etc., consumers end up spending their $$$ by bidding each other up for fixed assets like real estate)…

    Comment by vinod — November 30, 2006 @ 7:36 am

  2. Edward,

    You got it right for this quarter.

    Comment by Nitin — November 30, 2006 @ 3:49 pm

  3. [...] Edward Hugh, over at the Indian Economy Blog, argues otherwise. The argument here is, even in the absence of all of this in the short term how fast can India grow, and my feeling is that it can grow a lot faster than the Economist seems to think. My reasoning? I tend to give a lot higher weighting to the demographic component than most other commentators seem willing to do, and I also think that conventional analysis often ignores the speed with which behavioural change spreads (and this at the end of the day is an important part of the productivity picture) in an age of mobile phones and internet connectedness (which is another way of saying that we should expect ‘convergence’ to be much more rapid today than it was in the past. [IEB] [...]

    Pingback by The Acorn » Growing like never before — November 30, 2006 @ 4:04 pm

  4. Why is this Economist article being taken so seriously ? Another blogger had posted on this same article, but he’s cited some other points the article had raised.

    Do forgive my self promo but I’ve contested his points on this post on my blog .

    Edward, could you also explain what you meant by “I tend to give a lot higher weighting to the demographic component” ? Are you – and please correct me if I’m wrong – suggesting that the demographic content could actually push India’s GDP growth higher ?

    Thank you

    Comment by Bombay Addict — November 30, 2006 @ 7:02 pm

  5. 9.2% Growth in Q2

    Comment by Abhishek Nair — November 30, 2006 @ 8:03 pm

  6. I think the main issue here really boils down to productivity growth and what it really is. Population (and workforce) growth is fairly high and stable; and though it influences the trend rate quite a bit (as Edward notes), it is fairly predictable. I think our workforce has been growing at about a 2% rate or so – which would imply a trend productivity growth rate of 4.5% if Shah’s/Economist’s 6.5% rate is to be believed.

    My guess is that this number is probably higher – perhaps around 6%. This would still mean that todays 9.2% is “inflationary” – but not by terribly much. If anyone here knows where I can find good data on productivity growth in India, please let me know.

    Comment by Nandan — November 30, 2006 @ 10:18 pm

  7. [...] IEB’s Edward, an ardent demographic dividend proponent, argues that Economist and Ajay Shah may be wrong to say India is over heating and that there may not be a real worry for a crash or a recession anytime soon. Does second quarter growth of 9.2% prove that Edward is right? I am not so sure. [...]

    Pingback by INI Signal - » Growth Without Reforms - Magical UPA — November 30, 2006 @ 10:58 pm

  8. Bombay Addict,

    Are you – and please correct me if I’m wrong – suggesting that the demographic content could actually push India’s GDP growth higher ?

    Growth can occur due to higher labour productivity and a higher workforce participation rate. The demographic component affects the second part. Edward-again, correct me if I’m wrong.

    Comment by Nitin — December 1, 2006 @ 5:59 am

  9. Thanks for all the comments everyone. Sorry for the delay in replying but I had a very busy day yesterday.

    “You got it right for this quarter.”

    Thanks Nitin, I did cheat a little, since it was pretty clear from the Bloomberg survey that the results were going to be pretty good. otoh they did even exceed expectations. Also I was saying all this some three months ago.

    Vinod,

    “the problem that results is that even though you might have equiv aggregate demand growth, India faces supply side constraints which create the inflationary fears (e.g. instead of buying more cars / trucks / consumer goods / etc., consumers end up spending their $$$ by bidding each other up for fixed assets like real estate)…”

    This is certainly true, but my expectation is that the RBI will keep raising to try and take some of the heat out of this. Otoh there are global factors which are beyond their control. One of these is the level of interest rates in Japan, the United States and the eurozone. If these all start to reduce next year then it will be very hard for the RBI to push up longer term rates since the yield advantage (coupled with the high growth rate, and the expectation of more to come) will only attract an inward flow of funds which will tend to keep bond yields down. So they are facing really hard work on this front.

    The key issue is the extent to which investment can now take over. I go with Bhalla and our commenter Venkat and think that this is the big part of the picture people are underestimating, and especially if funds move into India, although here the Economist is right, this will have a balance of payments implication.

    The thing is a current account deficit to finance a consumer lead boom is one thing, and a CA deficit to finance infrastructural investment is quite another. Obviously to date India has been living with the former, but are we now about to see the latter take hold?

    Bombay Addict

    “Why is this Economist article being taken so seriously ?”

    Well quite. The Economist has a relatively poor track record on global economics of late, but still, it is the magazine everyone likes to read.

    “Edward, could you also explain what you meant by “I tend to give a lot higher weighting to the demographic component” ? Are you – and please correct me if I’m wrong – suggesting that the demographic content could actually push India’s GDP growth higher ?”

    Yes I am suggesting this, but it is quite a complex picture, since the demographics in Kerala and Tamil Nadu are quite different from those in, for example, Bihar and UP.Nandan makes a relevant point in this regard. Some parts of India are only at the begining of the DD (indeed Bihar and UP etc) are still a long way from approaching it. But one of the factors with the DD is that initially there are very big cohorts of relatively poorly educated workers, and this creates large problems in finding employment, and not a big deal in terms of productivity. So you get big GDP growth but not very spectacular growth in per capita income. Indeed the level pof life of the poorest sections of the population probably deteriorates, as has been found to be the case recently in China for the early years of this century.

    But then as these workers age things tend to improve, since they now have more experience, and hence more ‘economic worth’ while the smaller cohorts who arrive behind them tend to find access to employment easier (provided, of course, that economic development has taken place) and at the same time they tend to be better educated, and hence more valuable economically.

    This is all pretty complicated and by no means straight forward. I will post some more on all this in the near future.

    Nitin

    “Growth can occur due to higher labour productivity and a higher workforce participation rate. The demographic component affects the second part. Edward-again, correct me if I’m wrong.”

    No. That’s about it. With the rider as I indicate above that as the demographic tarnsition proceeds there is an inbuilt tendency for workers to become better educated and more productive. This is why it can become win-win. As I say, what really needs to be sorted out is the precise weighting to be given to the demographic part. At the end of the day this is the main difference between Ajay and me. I give a higher weighting to demographics, and at present I am coming up smelling of roses. Moving forward we will see more clearly. There is a lot to learn here.

    Comment by Edward — December 1, 2006 @ 2:52 pm

  10. [...] Related to recent discussion on whether Indian economy is heating up, this article on real estate boom is timely. The story is more or less the same all over India whether in the metros or emerging boomtowns. Property registration and clear titles are a serious enough problem in Kolkata for HSBC to ask the West Bengal Chief Minister to introduce on-line property registration. Before that happens, the municipal corporation must stir itself to issue proper occupation certificates. Mumbai does have on-line property registration, yet, harried apartment owners in a suburb discovered (only after receiving demolition notices) that their flats, financed by leading mortgage institutions, were constructed on illegally occupied forestland. [Indian Express] [...]

    Pingback by INI Signal - » Real estate bubble — December 1, 2006 @ 6:01 pm

  11. [...] We are presently having something of an ongoing debate here about how high trend growth might be in India at this point.  Now quite simply one part of this argument depends on demographics, and another on productivity. Productivity in India obviously needs to rise, and there are basically two ways that this can happen, have better human capital and accelerate technology transfer. [...]

    Pingback by The Indian Economy Blog » Wal-Mart and India — December 6, 2006 @ 7:20 pm

  12. [...] This is the rate at which an economy can (and should) grow without causing excess inflation. The current capacity debate (discussed here, here, and here), in essence, is about what this number is today. Ajay Shah, the Economist, and various investment banks (including Morgan Stanley and HSBC) have repeatedly said that India is overheated – evidenced most clearly by the run-up in inflation, and also by ‘bubble-like’ real estate and equity prices. Skittishness about the policy direction of the current governing coalition supports the prevaling belief that a crash (or, for the less brave, a “cooling down”) is imminent. According to them, economic growth and/or asset prices are both set to decrease in the near-medium term. [...]

    Pingback by The Indian Economy Blog » The Indian Productivity Miracle — December 21, 2006 @ 3:49 pm

  13. [...] here earlier in the year which put things pretty much in perspective and in October 2006 I had another piece in the IEB, basically in response to the Sizzling India article in the Economist, where I said: I am even [...]

    Pingback by The Indian Economy Blog » The Economist on India — December 20, 2007 @ 9:31 am

  14. But now due to the recession in US economy all the other integrated economies of the world are being are being affected including India. What is your view?

    Comment by Banerjee — February 23, 2008 @ 12:32 pm

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