Mains Paper: 3 | Economic Development
Prelims level: Monetary policy, Inflation
Mains level: Is the Indian economy hitting its speed limit a little too early in the recovery cycle?
• Is the Indian economy hitting its speed limit a little too early in the recovery cycle? The recent signs have been ominous.
• The monetary policy committee said in its statement earlier this month that the output gap has virtually closed, or that the economy is growing close to its potential.
• It did not give an explicit estimate about what that magic number really is.
• The sharp increase in core inflation in recent months is one indication that the output gap has narrowed to a sliver.
• Even the decline in headline inflation in July was driven by food prices rather than core inflation.
• Capacity utilization is also climbing for the first time in several years, if one goes by the enterprise surveys conducted by the Indian central bank.
What are the observations by IMF?
• The International Monetary Fund (IMF) has provided an estimate in its recent annual health check-up of the Indian economy.
• The multilateral lender has used several statistical filters to conclude that India’s potential growth was 7.3% in fiscal year 2018.
• It adds that potential growth is likely to increase to 7.75% in the coming years, as the recent economic reforms make an impact.
• The medium-term estimate of potential growth will be revisited once government statisticians release a longer gross domestic product (GDP) series under the new methodology in November.
• The IMF economists say that the recent uptick in potential growth despite the investment slowdown has been driven by productivity gains.
• They have not provided a detailed analysis of why productivity growth has emerged as the most important driver of economic growth over the past few years.
What are the possible ways to increase productivity in an economy?
• The first is when people shift from low productivity to high productivity sectors. The classic example here was the shift of millions from farms to factories across East Asia during its economic boom.
• The second possibility is when productivity increases as resources are reallocated within sectors, from low productivity to high productivity enterprises.
• The prospect of formalization of Indian manufacturing thanks to GST can be an important catalyst of intersectoral productivity gains.
Why then should they matter?
• The estimates of potential growth can give the political leadership a good idea of how fast an economy can grow without sparking off an inflationary fire.
• A low potential growth estimate should also hopefully lead to an internal debate about which economic reforms are needed to ease problems on the supply side.
• The macro policy can go off track without good estimates of potential growth.
• India saw this at the beginning of the decade.
• Policymakers continued to stimulate the economy through high fiscal deficits as well as low interest rates even as inflation reached double digits,
• The implicit assumption that Indian potential growth was still at its pre-2008 highs rather than declining.
• Most would remember the macro mess that led to the run on the rupee five years ago.
• India saw a sharp debate on potential growth a little more than a decade ago, especially after the publication of two papers by Barry Bosworth and Susan Collins, followed by a third one that the two American economists wrote in collaboration with Arvind Virmani.
• Some of the technical details were numbing, but the debate had profound policy implications.
• India needs a new version of the debate right now.
• It would be far more useful than airy hand-waving about double-digit growth.