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Subir Gokarn: The 10% stretch

Subir Gokarn  |  New Delhi 

Ten per cent growth will of a calibre we haven't seen
The year 2006-07 is turning out to be another 8 per cent plus growth year, the third in the last four. The average annual rate of growth over these four years will be in excess of 8 per cent. Most importantly, this rate has been achieved in a very stable macroeconomic context""low inflation, healthy balance of payments and an improving fiscal situation. With the threat of oil prices rising beyond this year's highs receding, the macroeconomic environment becomes even more conducive.
Given all these factors, it is not surprising that the Prime Minister thinks that achieving the 10 per cent growth milestone towards the end of the should not be too much of a stretch. But, current performance is the culmination of several actions taken in the past, whereas acceleration will depend on several actions that will be taken in the future. It is difficult to visualise a significant increase in the growth rate over the next few years in the absence of changes made, and quickly, on a whole variety of fronts. The Planning Commission itself, in both the mid-term review of the and the draft approach paper to the 11th, has referred to several policy measures that are critical to accelerating growth beyond current rates.
However, for most, if not all, of these, there is very little sign of either political support or administrative vigour in the current regime. The question, then, is: is there enough juice left in the reform measures initiated by previous governments to go from 8 per cent to 10 per cent over the next few years? Or, does 8 per cent represent a crest, at which the economy will linger for a while but, in the absence of new initiatives, inevitably descend from?
Let's visualise a scenario in which no economic reforms of any significance are initiated during the remaining tenure of this government. Even in this extreme situation, there are several factors that could conceivably keep the momentum going. Consumption spending has been a huge contributor to the four-year growth performance and looks likely to continue to play that role in the coming years. Decreasing relative prices of many consumer goods and services as a result of domestic and global competition, competitive pressures in retail finance and steadily rising incomes compound into a powerful force, even if each of the components may not be very large.
This is reinforced by the "wealth effect" of a sustained increase in asset prices. The spread of home ownership has magnified the impact of this factor. There may be a bubble element to real estate price movements, but even if there is and it bursts in the coming months, it is unlikely to wipe out the very substantial increases in prices over the last few years.
Investment in new capacity has also been a major contributor to growth over the past three years. Investment activity is characterised by a certain lumpiness, which means that capacity addition comes in spurts, exceeding immediate business requirements but anticipating a subsequent catch-up in demand. Investment spending, consequently, goes up sharply at the beginning of a cycle and declines just as abruptly once the desired capacity has been created.
We do not have much experience with the duration of investment cycles in an open, market economy context, but the current one has persisted for three years and really shows no signs of abating. It is quite possible that as businesses ratchet up their own expectations of growth (and new opportunities) in response to the favourable macroeconomic environment, new investments will continue to be made. The cycle will turn eventually, but, at least for the moment, it is clearly on the upswing. If one accepts James Tobin's q-theory of investment, which links asset price levels to investment activity, the current high asset prices also presage persistence in investment.
One important feature of the investment activity taking place is that it comes with workaround solutions to infrastructure constraints. No new manufacturing capacity comes without a captive power source. In fact, no new housing complex comes without this, either""it just wouldn't have a market. While such private solutions are inefficient from an aggregate perspective, they render the state of public infrastructure that much less of a constraint on consumption, investment and growth. They cannot become a permanent alternative, but they do provide breathing space and allow the momentum to persist, even perhaps the power to accelerate.
Exports of both goods and services have been a third engine of growth in recent years. India's merchandise exports are quite diversified geographically and, therefore, not very vulnerable to localised business cycles. Finally, all these three engines are being given an additional boost by what appears to be a sustained, across-the-board increase in productivity, which again shows no sign of flagging.
Left to themselves, these forces may well be powerful enough to move from the current 8 per cent equilibrium to a 10 per cent one a few years down the road. But, obviously, that is not the case, as so many observers, including within government, keep pointing out. There is only so much that workaround solutions for infrastructure can do to offset the yawning supply gap in most sectors. And, workers are not shifting from farm to factory and office fast enough. Both these are major threats to the sustainability of the growth engines described above. But, these are well-known; there are other threats on the horizon as well.
For example, service exports are competing less with third countries than with a pull-back towards consuming countries. Part of the problem is governance, as in data and IPR protection, but a significant reason is the narrowing of the cost differential. Perhaps somewhat ironically in an economy that has always been viewed as labour-abundant, the availability of many kinds of skills is simply not keeping up with demand, leading to massive increases in salaries and a consequent erosion in competitiveness.
The more general point is that rapid growth tests supply-responses across a variety of sectors and some of these will be found wanting, more so if a powerful supply-response is dependent on any action""policy, regulatory or investment""by the government. Of course, some of these bottlenecks will be eased by low-level reform measures by the government, but these are unlikely to provide the boost that is needed to move from 8 per cent to 10 per cent.
To sum up, even with very low expectations about reform initiatives, sustaining 8 per cent seems realistic. Let's not underestimate the significance of this. But, 10 per cent? This will of a calibre we haven't seen And, there certainly isn't any prospect of that.
The author is chief economist, Crisil. The views here are personal

First Published: Mon, October 23 2006. 00:00 IST