“Reversing the reversal”, ‘Business Line’, November 28, 2014

By 2007-8 the economy had grown at over nine percent per annum for three consecutive years. The last time the economy had exceeded the nine-percent mark for growth was in the late 80s, and that too in a single year. At that time it was so unexpected, and its continuation so inconceivable, that it did not provide cause for comment. This time though, the repetition of the outcome over three years had given rise to the expectation in some circles that it was only a matter of time before the double-digit growth barrier would be breached. But this was not to be. In an unexpected reversal we now have a situation in which growth has been trending downwards and settled at less than 5 percent in 2012-13. At the same time, mid-way through the decade, inflation may be seen as having shifted gear forward. Since 2008-09, headline inflation measured by the rate of change of the wholesale price index has mostly been much higher than in the first half of the decade.

          So the principle stylized fact of the decade upto 2012-13 is that somewhere in the middle of it a macroeconomic regime switch took place. The behavior of their time series prompt the following observations. First, the decline in growth since 2008-09, except over the period 2009-11 when it was possibly shored up by the ‘Mukherjee Stimulus’, suggests something systematic at work. Secondly, that the growth-inflation history of the second half of the decade is a mirror image of what it was in the first presents the possibility of a third factor having caused the reversal.

The role of global factors

It could not have escaped anyone’s attention that the commencement of the slowing of growth in 2008-09 followed closely in time the onset of the financial crisis originating in the US in 2007-08 and the global slowing that had followed. However, growth in India has contracted much more than in the rest of the world and in China taken on its own. This despite India’s share of world trade being lower and the share of exports in its GDP being less than in China. Of course, that growth in India has slowed more than in other countries is not by itself clinching evidence that global factors cannot account for all of the decline. For instance, if following the global financial crisis international investment flows had diverted funds from India to the rest of the world then this would have slowed growth in India. Though the rate of accretion of FDI to India has slowed, foreign investment inflows are far too small in relation to the economy to have made a major difference. In the year 2007-08 they had amounted to 7.3 percent of gross domestic capital formation and 2.9 percent of the gross national product, respectively. With respect to inflation, on the other hand, we find that it has fallen in all parts of the world, including in China, but risen substantially in India. The data suggest the following. While global factors may well have impacted growth in India, we have reason to believe prima facie that domestic factors have been at work too. By comparison, we need entertain little doubt that the rise in inflation in India must owe largely to factors specific to this country as it has actually declined elsewhere.

Accounting for the regime change

Two factors account for much of the slower growth and higher inflation during the second half of the last decade, namely slowing agricultural growth and declining public investment.  It had commenced with two years of near-zero agricultural growth and was generally a period of fluctuation in agricultural output. Thus, after a smart recovery mid-way through, the period ended with low growth once again. Finally, to attempt another characterisation, there was only one ‘bad’ year in its first half of the decade compared to three in its second. So, howsoever it is viewed, the latter half of the decade is distinctly one of lower agricultural growth. Repeated negative agricultural supply shocks generated inflation in this period contributed to rising in. For households whose income growth does not keep pace with the rising price of food, higher expenditure on food must crowd out spending on industrial goods. Note that the real price of food has risen by close to 25 percent since 2008-09. Industrial production has declined from 2010-11, and has more or less ground to a halt by now. Of course, it is not necessary that all of this is related to the slower agricultural growth. In fact, we may state right away that this is unlikely for the slowdown in industrial growth is far too dramatic. I now turn to this other aspect.

The role of macroeconomic policy

The one element of macroeconomic policy across the decade that is most closely linked to growth is public capital formation. Public capital formation rose sharply upto 2007-08, fell sharply in the next year, and has remained depressed since. Two further observations may be made on the basis of the data in the table. First, while private capital formation has declined from 2009 onwards its fall is not as precipitous as that in the public. Capital formation in the private sector actually more than revived by 2012-13, when it exceeds its previously attained peak by over 20 percent, without being able to make a difference to the overall growth rate. Secondly, the steep decline in capital formation in the public sector in 2008-09 took place as the fiscal deficit expanded by over one hundred percent. So, at this time, government expenditure could not have been not financially constrained in the aggregate. Only further research can establish then whether the government was primarily motivated by the desire to increase consumption, both its own and of the private sector via subsidies, or by that of supporting growth. Whatever be the case, the steady decline in public capital formation signals that the government may have seriously misjudged the growth dynamics in assuming that growth would continue regardless of the composition of the spending. It is of interest that private capital formation did not fall as steeply as capital formation in the public sector. In fact, in no year did it fall to a level below the lowest one registered during the period of fast growth over 2003-08. So, overall, there is strong evidence to suggest that the public sector may have contributed more to the growth decline than the private sector by reducing its capital formation after 2007-08. The magnitude of the reduction is brought home by the statistic that by 2012-13 public capital formation as share of GDP was less than half of what it was in 2007-08.

          So what would it take to reverse the reversal? On inflation a steady agricultural growth is necessary. Where this would depend on the natural factors there are few short term fixes. However, government can manage stocks far better and operate procurement price-fixing more judiciously. For a revival of the growth momentum, increasing public capital formation would have to be part of the plan. Mr. Jaitley has spoken of FDI and PPP in his first budget. Since then he has berated the RBI for the rigidity of its monetary policy stance. Now he should focus on what he can do for a more robust growth.

Excerpt from the Malcolm Adiseshiah Memorial Lecture delivered at Chennai on November 21. The author may be reached at www.pulaprebalakrishnan.in.