Economic Growth in India

india-lf.gifMy postings on India here on AS have primarily been driven by my interest in the Indian retail sector and how big foreign retailers are trying (and for some failing) to enter the promised land typified by India's consumer market.

This post does not grind down to the micro level but stays in the realms of macroeconomics where I will point you to a tour-de-force article (+comments!) by Nanubhai over at the Indian Economy Blog. In essence, I am only pointing here and I can highly recommend you to drop by the IEB and read it. However, I would like to highlight a couple of things from Nanubhai's post.

As it has been pointed out by many lately (see links in Nanubhai's post) India is on the brink of economic overheating as a result of the blistering pace the economy is going at. Yet, this analysis rests (quite naturally) on the idea of a given rate of trend growth and as you will see this is the main issue here. What is in fact India's trend growth rate?

'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.'

In the following Nanubhai engages in a meticulous analysis of economic growth in India with the aim to establish a foundation to assess the level of trend growth but ever more importantly we are also looking at factors which influence trend growth. And the conclusion ...

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% (5% TFPG + 2% labor force growth + 1% capital deepening) with the capacity to reach 10% (4.5% + 3.5% + 2%) 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.

As we can see, one of the fundamental drivers of growth in India is the growth of the labour force or more specifically the demographic dividend which is defined as the period during the demographic transition where the labour force increases as the economy sees a net gain in workers. There are consequently some important points here and the first is that the demographic transition displays a very direct impact on economic growth but also more generally on the macroeconomic environment and ultimately also macroeconomic indicators. Another crucial consideration here is of theoretical nature and essentially has do to with the nature of the demographic transition's impact on the economy. In terms of Nanubhai's post we can see this in the end where he says ...

'(...) even the most pessimistic observer must see that the [cyclical economic] 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.'

What we have here is the recognition that whereas India today and for the decade to come will be enjoying, all things equal, a steadily rising growth trajectory this will not go on forever and how India leverages that advantage today has immense effects on the future of the Indian economy. For me (and Nanubhai) to argue as such we are incorporating in our analyses the idea of path dependancy concerning the impact of the demographic transition on the economy. Edward also noted this point in a recent article over at DM on immigration.    

This allows me to finish with a main point ...

If we can accept the conviction that the demographic transition and indeed the demography of a country displays a very direct transmission mechanism towards economic factors, performance, and growth we also need to recognize that this effect is not linear and indeed that this effect is very difficult to model since it is path dependant. This is the real lesson here and it is a basic recognition I believe we need to integrate into our thoughts on this.