Back in the late 1990s, economists were trying to figure out what it was that led to the secular acceleration of economic growth in the United States: the longest and largest peace-time economic expansion in the 20th century (see footnotes). How was it that a country could grow so much and for so long without causing inflation and overcapacity? Was the business cycle dead?
Clearly not: the financial crash that followed was swift and brutal – making investment bankers’ Christmases depressing for all of two years. Indeed, the accompanying recession was the shortest and shallowest in US history (click to see on the chart below).
During the boom, the US economy benefited from an unprecedented acceleration in productivity growth. This was driven primarily by the efficiencies created by technological and financial deepening – particularly in the retail, wholesale, electronics, semiconductors, and financial services industries. While the dot-com’s and Stanford techies in pastel suits got the glory, the economy itself was being powered by the Wal-Marts, Intels, and GEs – who were innovating rapidly – and implementing that innovation in long-term strategies to enhance their bottom line.
Now before I get to how this compares to India today, a brief economics refresher. According to neoclassical theory, at the most basic level, a country’s output is powered by structural and cyclical forces. Structural or long term growth is driven by three factors inherent to the economy: the number of workers, their productivity, and how much long-term capital is available to them. Cyclical growth is powered by the various short-term influences on the economy: wealth effects from the asset markets, monetary and fiscal policies, etc. In theory, an economy should grow at its structural (or ‘trend’) growth rate plus or minus the cyclical component. To simplify, a country trend level of annual real GDP growth should equal:
Y% = (% change in labor force) + (% change in productivity)
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.
They may well be right. Nevertheless, it is worth taking a look at the numbers and seeing exactly what has been powering economic growth in India over the last couple of decades. If we want to figure out where the Indian economy is headed over the next 4-5 years (as opposed to say, the next 4-5 quarters), surely this is better than looking only at the short-term indicators.
Our potential workforce (defined as people aged 15-64) has been increasing at about 2% a year – and is projected to continue at that rate at least till 2020. However, labor force participation rates vary substantially from state to state, between the sexes, and between rural and urban areas – as do unemployment and underemployment. Given that labor force growth (potential workforce x overall participation rate) has been averaging about 2% over the past 10 years, in the absence of better statistics, it is a safe assumption that overall employment is growing in the range of 1-2% and gradually accelerating.
The rest of real GDP growth has to come from growth in the productivity of those workers. In this framework, there is one fixed determinant of productivity growth: the capital-to-labor ratio. When capital is substituted for labor, then up to a point, this increases the productivity of labor. The rest of productivity growth is lumped up into a residual which economists call total factor productivity growth, or TFPG. While there is considerable debate on this, there is strong evidence at the national and industry level that TFPG is correlated strongly with measures of competition, deregulation, technology and innovation (much more on this in a later post). For the purposes of this analysis, we can simply say that TFPG is the component of growth which captures the extent of the structural change in an economy.
By running the calculations over the 1980-2005 period using real GDP, capital stock, and the labor force as the variables, we can see a relatively clear trend in India. Labor force growth has been fairly steady around 2%, and capital deepening has been a fairly small contributor to growth (on average 1.5%). Predictably, the acceleration in GDP growth since 1991 (and through much of the 1980s) has been almost entirely because of an increased pace of TFPG.
india tfpg.ppt (Updated chart)
The 5-year averages in the chart hide an even bigger change: if you look at the breakdown from 2004-2006, TFPG has been almost 5%. This acceleration has been partially due to changes in government policy, but my guess is that a larger portion of it is driven by the impact of the natural forces of globalization. The internet and the opening up of global financial markets has allowed a boom in IT enabled and financial services, and the loosening of trade barriers has boosted industry. Furthermore, there have been massive changes in the way Indian companies do business: ranging from increased transparency in order to tap the capital markets, aggressive cost-cutting and outsourcing of non-core functions, and an increased pace of technology transfers – both from abroad, and within industries. All of this impacts the productivity of labor (and TFPG) at all levels of the economy – and in another sense, is the very definition of ‘structural change’.
While there is an eventual limit to how much all these factors can influence productivity, it is my contention that we are a long way away from that point. When our leaders remind us that the reform process is “irreversible”, it is not just a diplomatic nicety to appease investors; it is in fact the truth. The forces of competition unleashed over the last 15 years cannot proverbially be brought back into the box – they will continue until they run their course; until all those who want to and can take advantage of the benefits of a more-open economy, have done so. Further policy changes have the ability to increase or decrease the magnitude and the speed of this change – but they cannot alter its direction.
If this were the extent of the change, it might alone be enough to help India out of chronic underdevelopment. Fortunately, the extent is even bigger. Along with the acceleration of TFPG, we will most likely soon see an acceleration in capital deepening as well, and soon thereafter in the growth of the labor force. The investment to GDP ratio has risen by about 5% from 1991 to now. Most economists are expecting a further increase once the numbers for the current fiscal are released – the prevailing estimates are that it will be about 29-30% of GDP. Surjit Bhalla of Oxus is even more optimistic, saying that it will increase to over 35%. As long as this investment boom lasts – and there are some reasons to believe that a lot of this is long-term capital, not just short-term ‘hot money’ – the capital deepening portion will continue to accelerate. And, as I mentioned earlier, sometime between 2009 and 2015, labor force growth will peak around 3.5% – 4%. This alone would constitute a 2% acceleration from the current trend level of GDP growth.
Now the real heart of the capacity debate centers around this question: what is India’s trend rate of growth now and what will it be for the next few years? (This is the red italicized number in the previous chart) If you add up the numbers, it seems to me that at a minimum, trend growth is at 8% with the capacity to reach 10% in the coming years. The 6.5% baseline level of growth that the Economist and others use to form their assessments of the Indian economy is fundamentally flawed. Any judicious accounting of the productivity trend over the last 25 years, when combined with stable and high labor force growth, should reveal that, over the long-term, the ‘supply-side’ of the economy is advancing at an accelerating rate.
Now, all this is not to say that ‘India-bears’ don’t have legitimate concerns: accelerating inflation, rapidly increasing asset prices, and a lack of sufficient policy direction are all worrying signs. But one must clearly distinguish between short-term fluctuations, and the long-term trend. On the fiscal front, the government is clearly too profligate: spending by the centre as a percent of GDP has increased by 2% over the past three years. The RBI (on account of persistent goading from North Block) has not increased short-term interest rates enough, with real rates continuing to decline. And, as our recent discussion about the real estate “bubble” highlighted, asset values are quite clearly borrowed against future growth.
However, all this does not
necessarily add up to unmitigated disaster. High productivity growth is the closest thing to a panacea that central bankers can find these days – it tends to keep long-term inflation expectations down. The recent run-up in prices can be explained by short-term capacity constraints (particularly in agriculture), and an increase in oil prices in the first half of the year. Similarly, on the fiscal front, we are extremely unlikely to see a fiscal stimulus of the type introduced over the last three years (in particular the employment guarantee scheme). Moreover, high growth and structural change have allowed the tax base (% of workers that pay taxes and tax/GDP) to expand rapidly. This has allowed for a gradual change in the nature of government spending, with direct subsidies growing slower and direct investment growing faster. (Having said all that, I will admit that state finances are a complete bloody mess).
As for the asset markets – even after the run-up of the SENSEX, India’s market-cap to GDP ratio is still around 95%, which is lower than countries like South Korea (100%) and South Africa (240%), as well as developed capital markets (which range from 120% – 400%). Similarly, to summarize our earlier discussion, real estate has exhibited some disturbing trends in some regions, but on the whole, the jury’s still out on whether this means that it’s a nationwide price bubble.
To conclude, India faces some real risks in the short-term. If I had to give my top three, they would be:
- Supply bottlenecks (particularly in agriculture and industry)
- External environment (particularly turns in the global growth and liquidity cycles)
- Frothy asset values (particularly those which are borrowed against unreasonable future growth)
Nevertheless, any sober analysis will reveal that in the midst of unprecedented structural change, it will take a lot more to knock India off its long-term growth trajectory. Of course, we should expect to see fluctuations – sometimes big ones. However even the most pessimistic observer must see that the fluctuations are happening around a steadily increasing mean. Amidst this rapid transformation, India’s progress and prospects cannot be best judged month-to-month or quarter-to-quarter – but rather year-to-year, and in some instances, even decade-to-decade.
In India, we must see this as a golden opportunity to get our house in order: start cleaning up governance and the budget; build infrastructure; and balance growth between the regions. All these things will be much harder to achieve when (and if) the going gets tough.
In other words: don’t worry too much, but don’t get complacent either.