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Two Issues in India’s Growth Story
C. Rangarajan*
This article discusses two issues in relation to India’s
growth performance.
One is on the determination of the
potential rate of growth of the Indian economy and the other on
the estimation of the threshold level of inflation, the level of
inflation beyond which growth turns negative.
Potential Rate
The Indian economy is currently passing through a phase
of relatively slow growth. However, this should not cloud the
fact that over the eight year period beginning 2005-06, the
average annual growth rate has been 8 per cent. Against this
background, a frequently asked question is whether India has
the potential to grow at a sustained growth rate of 8 to 9 per
cent potential rate.
Normally, potential growth is measured using trends and
filters like the H-P. In one sense, these are backward looking
measures, since they depend on historically observed data. In
the case of measuring capacity utilization, the maximum
*
Extracted from the Address at the Golden Jubilee of the Indian Econometric
Society held on December 22, 2013 at Mumbai.
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capacity is very often taken as the maximum output achieved in
the recent period. In any case, in the case of determining the
potential rate of growth of the economy one can take the
maximum growth rate achieved in the recent past as the lowest
estimate of the potential.
This assumption can be made, if
there is reason to believe that the maximum growth rate
achieved in the recent past was not an one-off event and the
growth rate achieved was robust. India achieved a growth rate
of 9.5 per cent in 2005-06 followed by 9.6 per cent and 9.3 per
cent in the subsequent two years. After declining a bit in the
wake of international financial crisis, growth rate went back to
9.3 per cent in 2010-11.
In many ways the growth rate
achieved in the high phase period of 2005-06 to 2007-08 was
robust. The domestic savings rate during this period averaged
33.4 per cent of GDP. Similarly, the gross capital formation
rate averaged 34.2 per cent.
The current account deficit
remained low with an average of 1.1 per cent of GDP.
Agricultural growth during this period averaged 5 per cent and
the annual manufacturing growth rate was 11.5 per cent. The
capital flows were large but as CAD remained very low, the
accretion to reserves amounted to $144 billion. Thus on many
dimensions the growth rate was robust. It was not just fuelled
by financial availability.
Certainly, the external environment
provided good support. This was the period during which the
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world economy was also booming. The growth rate slowed to
6.2 per cent in 2011-12, even though the rate may be revised
upwards. It came down to 5 per cent last year and this year it
is expected to be around the same level. The savings and
investment rates have come down significantly from the peak
reached in 2007-08, partly due to economic and partly because
of
non-economic
factors
such
as
perception
towards
governance and policy framework. Nevertheless, recent data
indicate that in 2011-12 the gross fixed capital formation rate, a
measure of the accumulation of fixed assets by business,
government and households,
was around 30.6 per cent as
against 32.9 per cent of GDP in 2007-08 (Table 1). In normal
conditions, keeping in view the recent trends in ICOR (the
Incremental Capital Output Ratio) which is around 4, this
should have given us a growth rate of 7 to 7.5 per cent but the
actual rate turned out to be 6 per cent. Economic growth has in
fact declined much more steeply than what is warranted
by
the decline
projects
have
in
investment.
not
been
This may
because
completed in time or
complementary investments have not been
Table 1
Savings and Investment Rates
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be
forthcoming.
(as a proportion of GDP)
2007-08
Gross domestic savings rate
Households
Financial assets
Private corporate
Public sector
2011-12 Change over
the period
36.8
22.4
(11.6)
9.4
5.0
30.8
22.3
(8.0)
7.2
1.3
(-) 6.0
(-) 0.1
(-) 3.6
(-) 2.2
(-) 3.7
Gross Capital Formation
Public sector
Private corporate
Households
Valuables
38.0
8.9
17.3
10.8
1.1
35.4
7.9
10.6
14.3
2.7
(-) 2.6
(-) 1.0
(-) 6.7
(+) 3.5
(+) 1.6
Gross Fixed Capital Formation
Public sector
Private corporate
Households
32.9
8.0
14.3
10.6
30.6
7.4
9.7
13.6
2.3
(-) 0.6
(-) 4.6
(+) 3.0
In some cases, this could also be due to non-availability of
critical inputs such as coal and power.
The fact that even
today, savings and investment rates are at high levels reassures us that if we are able to find ways to complete projects
speedily, we shall be able to usher in rapid growth in income
even in the short run. It is, however, to be noted that while the
decline in overall gross fixed capital formation rate from the
peak reached in 2007-08 was only 2.2 per cent, the decline in
the case of private corporate sector was as high as 4.6 per
cent. Thus the composition of investment has also played a
role in the reduction in productivity of capital. Nevertheless,
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while the existing level of investment rate should enable us to
grow at 7.5 per cent in the short run, a return to higher level of
savings and investment can take us back to the very high levels
of growth which we had seen earlier.
To assess whether we will be able to get back to the high
savings and investment rates of the previous period, we need
to look a little more closely at some of the macro economic
parameters during the low growth phase. The gross domestic
savings rate fell by 6 percentage points between 2007-08 and
2011-12. However, the decline in the investment rate was less.
It fell from 38.1 per cent in 2008-09 to 35 per cent in 2011-12
which is a decline of 3 percentage points. The lower decline in
the investment rate is accounted for by the fact that the current
account deficit rose from 2 per cent of GDP in 2007-08 to 4.2
per cent in 2011-12. Looking at the domestic savings rate, of
the decline of 6 percentage points more than half was
contributed by the decline in public sector savings. During this
period, the fiscal deficit rose sharply.
Within household
savings, there was a sharp decline in the ratio of savings in
financial assets to GDP by 3.6 percentage points, mostly due
to high inflation. Going ahead, we should build in only a more
modest current account deficit of about 2.5 per cent of GDP.
Several studies have shown that this is the only sustainable
level of CAD taking into account the normal capital flows. In
fact, even a somewhat lower level of CAD will be desirable.
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Thus to get back to anything like 8.5 per cent growth rate, there
has to be some pick up in the domestic savings rate from the
current level.
For this to happen what is needed is fiscal
consolidation. Thus with a modest current account deficit of 2.5
per cent of GDP and a savings rate of 32 per cent of GDP, one
can expect the Indian economy to grow at 8.5 per cent. Thus
to sustain a long term growth rate of 8.5 per cent, three things
need to happen: (1) CAD must be lowered, (2) the domestic
savings rate must pick up with much of it coming from fiscal
consolidation, and (3) the productivity of capital should improve
so that incremental capital output ratio is maintained around
4:1.
Given the performance of the Indian economy in the
recent past, these are not impossible tasks. But this will require
focussed efforts on all the three fronts. Besides, we need to
keep a watch on inflation which also has a bearing on the
potential rate of growth when it exceeds a threshold level.
Threshold Level of Inflation
During the last three years not only has growth slowed
down but inflation has been on the rise. Inflation as measured
by the wholesale price index stood at 10.9 per cent in April
2010, 9.7 per cent in April 2011 and 7.5 per cent in April 2012.
As of April 2013, it came down to 4.8 per cent. However, there
has been a pick up in inflation since then. As of November, it
has come to 7.5 per cent. It is, in this context, a question has
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been raised as to the acceptable or threshold level of inflation.
The threshold level of inflation is that level of inflation beyond
which inflation has a decisive negative impact on growth.
A case for low and stable inflation has been persuasively
made in the literature.
The volatility of prices creates
uncertainties in decision making. Rising prices adversely affect
savings while they make speculative investments more
attractive.
These apart, there is a crucial social dimension
particularly in developing economies. High inflation adversely
affects those who have no hedge against it and that includes all
the poorer sections of the community. This is indeed a very
strong argument in favour of maintenance of low inflation and
price stability in emerging economies.
Empirical evidence on the relationship between growth
and inflation in a cross country framework is somewhat
inconclusive because such studies include countries with an
inflation rate as low as 1 to 2 per cent to those with inflation
rate going beyond 200 to 300 per cent.
These studies,
however,
rates
clearly
establish
that
growth
become
increasingly weaker at higher rates of inflation. However, in
recent years, studies have been done to test the inflationgrowth trade off by using each country’s time series data.
There are two methods which are adopted. The first one is to
regress the annual GDP growth on fundamental factors such as
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investment, coupled with inflation and square of inflation. The
estimated equation is applied for different levels of inflation to
find out inflection point or threshold beyond which inflation has
negative impact on GDP. The alternative method uses apart
from fundamental factors such as investment two variables
related to inflation. One variable is the level of inflation and the
other a dummy variable which takes on the value of 0 or 1 for
different levels of inflation.
Threshold level is that level of
inflation which minimizes the residual sum of squares of the
regression equation. At that level, inflation has a significant
negative impact on growth.
Using the observations for the
period 1982 to 2009, under the first method of estimation, the
point of inflection occurs at 6.3 per cent. Under the second
method also, the threshold level of inflation seems to fall
between 6 and 7 per cent (see Annexure 1). However, when it
comes to the acceptable level of inflation for policy guidance,
we need to work with a lower level of inflation for two reasons.
First, the estimate of trade-off does not take into account the
distributional implications of inflation.
inflation is way above what
Second, this level of
other countries have treated
as acceptable level of inflation. This will have implications for
the exchange rate. While open economy helps to overcome
domestic supply shocks, it also imposes the burden to keep the
inflation rate in alignment with other countries.
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Annexure 1
Estimating the threshold level of Inflation*
To estimate the non-linear relationship between inflation and growth two methods have been
adopted.**
Method 1
Here we used a model, where the inflation itself captures the non-linearity. The annual GDP
growth is regressed on Inflation, square of inflation and growth in Gross Domestic Capital
Formation (GDCF).
𝑮𝑫𝑷𝒈𝒓𝒐𝒘𝒕𝒉𝒕 = C + 𝜷𝟏 𝑰𝒏𝒇𝒍𝒂𝒕𝒊𝒐𝒏𝒕 + 𝜷𝟐 𝑰𝒏𝒇𝒍𝒂𝒕𝒊𝒐𝒏𝟐 𝒕 + 𝜷𝟑 𝑮𝑫𝑪𝑭𝒈𝒓𝒐𝒘𝒕𝒉𝒕 + 𝜺𝒕
The estimated equation is applied for different levels of inflation to find out the inflection
point, or threshold, beyond which inflation has a negative impact on GDP growth
Using the data for the period 1982 to 2009, the following equation was estimated
𝐺𝐷𝑃𝑔𝑟𝑜𝑤𝑡ℎ𝑡 = -2.29 +1.90*𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛𝑡 -0.150* 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛2 𝑡 +0.30* 𝐺𝐷𝐶𝐹𝑔𝑟𝑜𝑤𝑡ℎ𝑡 + 𝜀𝑡
S.E
(3.2)
(0.86)
(0.06)
(0.03)
t- Value
(-0.73)
(2.2)
(-2.5)
(9.6)
R-Square
0.89
* denotes significant at 5%
Based on the equation the following relationship between growth and inflation is derived
Point of Inflection: 6.3
*
**
I am grateful to Shri. Vibeesh E M for his help in estimating the equations.
Both the models presented here suffer from one limitation. They do not take into account
explicitly the impact of inflation on variables such as exchange rate and income distribution.
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The point of inflection occurs at an inflation of 6.3 per cent.
Method 2
The method developed by Khan and Senhadji (2001) (by using GDP growth as endogenous
variable and inflation and Growth of Gross Domestic Capital Formation as exogenous
variables) is used to estimate the threshold level of inflation.
The equation estimated is of the following form
𝑮𝑫𝑷𝒈𝒓𝒐𝒘𝒕𝒉𝒕 = C + 𝜷𝟏 𝑮𝑮𝑫𝑪𝑭𝒕 + 𝜷𝟐 𝑰𝒏𝒇𝒍𝒂𝒕𝒊𝒐𝒏𝒕 +𝜷𝟑 𝑫𝒕 (𝒌) + 𝜺𝒕
Where Dt (k) is a Dummy variable defined as,
Dt (k) = 1 if inflationt > k
0, other wise
The parameter k helps to determine the threshold inflation level. In the estimated relationship
𝛽2 captures the impact of the inflation on growth, 𝛽3 explains the impact of inflation
exceeding threshold on growth. At the threshold level of inflation, not only both 𝛽2 and 𝛽3
should be statistically significant but also that 𝛽2 should be positive, 𝛽3 should be negative
and sum of two coefficients, (𝛽2 + 𝛽3 ), should be negative and statistically significant.
While the value of k is given arbitrarily for the estimation, the optimal k is obtained by
finding that value of k that minimizes the residual sum of squares (RSS). Thus, the threshold
level is that which minimizes the residual sum of square (RSS). Inflation at this level has a
significant negative impact on economic growth.
Estimated equation for the period 1982 to 2010
𝐺𝐷𝑃𝑔𝑟𝑜𝑤𝑡ℎ𝑡 = 2.8* +0.29* 𝐺𝐺𝐷𝐶𝐹𝑡 +0.20** 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛𝑡 – 1.1*𝐷𝑡 ( 7%) + 𝜀𝑡
S.E
(0.86) (0.03)
(0.12)
(0.27)
t value
(3.2) (10.3)
(1.7)
(-3.9)
R-Square
0.88
Minimum Residual Sum of Squares: 3.6
Test, 𝛽2 + 𝛽3 = 0 Value: -0.87, P value: 0.01
*, ** denotes significant at 5% and 10% level respectively
The sign of 𝛽2 + 𝛽3 become negative when k crosses 6 per cent and reach the least Residual
Sum of Squares at optimum when k=7.0 per cent. Therefore we can conclude that the
threshold level of inflation for this period was between 6% and 7%.
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References
Khan, Mohsin and A S Senhadji (2001), “Threshold Effects in the Relationship between
Inflation and Growth”, IMF Staff papers, Vol 48, No 1
Pattaniak, Sitikantha and Nadhanael G V (2011),“Why Persistent High Inflation Impedes
Growth? An Empirical Assessment of Threshold Level of Inflation for India”, RBI Working
Paper Series, W P S (DEPR) 17/2011
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