What next with GDP growth?

Business standard, 21 January 2004

There is a lot of excitement about high GDP growth in 2003-04. Growth in the 2nd quarter was 8.4%. CMIE recently upgraded their estimate for growth in 2003-04 from 7.4% to 8.2%.

There is an undeniable magic in getting above 7.5% - it upgrades India's standing in the world, and improves investor confidence. More good news is in the offing. The corporate results that will come out in coming months are also likely to show strong growth rates of revenues and profits. Jaswant Singh has said that the next two quarters will also show growth above 8%.

Is this growth simply a low base effect? With the drought last year, growth dropped to 4.3%. Suppose this year had merely been a return to the trend growth rate of 6%. Then we should have got growth of 7.7%. We seem to be faring a bit better than this.

What does 2004-05 hold? India has had only one episode in history, where growth in consecutive years was above 7%: This was in 1994-95, 1995-96 and 1996-97, where growth was 7.25%, 7.34% and 7.84%. Apart from this, there has never been a pair of consecutive years above 7%. So the interesting question is: will 2004-05 be different?

There are positive and negative consequences of the very good monsoon in 2003-04. Some of the GDP impact of this monsoon will show up in 2004-05. But at the same time, it is unlikely that we will get high agricultural growth next year. High growth in 2004-05 requires very strong growth in industry.

What was the magic that worked from 1994-95 to 1996-97? It was an investment boom, triggered by the reforms of the early 1990s. Economic reforms triggered optimistic expectations, which led to investment. The investment decisions made by companies in 1993 and 1994 had a delayed impact on investment and GDP growth, which showed up from 1994 onwards.

In the present feel-good scenario, expectations are high. It is possible that we could see a strong growth in investment which could push up GDP growth in 2004-05 to above 7%. In a number of ways the economy is better equipped to handle an improved investment climate. A large number of bottlenecks that existed in the mid-1990s have today been eased. While expectations in the 1990s were based more on hope today they are based far more on hard reality, an improved infrastructure, a better understanding of the potential and the constraints that exist in the economy today. Companies are much better prepared today to take on competition and have effectively improved efficiency in the last few years.

Another big difference from the 1990s is the drop in customs tariffs. Low tariffs reduce uncertainty about future difficulties caused by tariff reductions, and encourage investment. Every investor in India in the early 1990s had a damocles sword over his head, about what would happen when India opened up. Things are much better now. At the same time, it is important to point out that what India claims is a `peak' rate is a white lie. The true peak rate is enormously higher.

As with the early 1990s, the stock market is booming. High stock prices are necessary for sending out signals to firms to invest. When the price to book ratio is 2, this means that Rs.1 of investment turns into Rs.2 of wealth. This is likely to give substantial resource mobilisation on the primary market. If a string of IPOs come about, which appears likely, then many venture capital firms will obtain profits by selling off their bets of the 1990s. This will (in turn) generate a fresh set of VC investments in young companies.

A useful difference from the early 1990s is the demise of DFIs, the downsizing of UTI and improvements in banking regulation. This should reduce the incidence of incompetent decisions by banks, as happened in the 1990s and as has happened in China. On the securities markets, infrastructure has improved dramatically. In the early 1990s, when FII investment rose sharply, inflows choked owing to the difficulties in handling physical paper. In 2003, a similar sharp rise in FII investment was competently handled by the securities infrastructure.

Large investments that are required in infrastructure seem far more possible today than they have been in the past. For the first time, it now seems that the regulatory and policy impediments have been significantly addressed in four areas (roads, telecom, ports, electricity). Large investments in airports also appear likely. These could help ignite new projects that were held back by poor facilities. Only railways have been largely untouched by the reforms process, and there is no possibility of obtaining a sharp rise in investment in railways.

For example, we have long talked about the need to dramaically grow teledensity. Now, for the first time, we are at a point where 100 million lines will realistically be added in two years, and this innately implies certain investment flows will take place. Similarly, investments in the electricity sector may grow dramatically owing to the Electricity Act. Given the right investment climate, there could easily be Rs.100,000 crore of investment in these areas in 2004-05. This would be a good foundation of an investment boom.

FDI is another area which fits this general pattern. Ten years ago, when global companies woke up to the importance of India, they faced a quagmire of difficult procedures, which converted optimistic investment intentions into a trickle. Ten years later, India is once again high on the radar of global companies, and when they make decisions to build operations in India, the FDI framework that we have has experienced one decade of criticism and improvement.

This adds up to a picture where considerable investment demand could come about, which could give high growth in 2004-05. However, in addition to all these strengths, there are things that could go wrong. In 2004-05, we could have a bad monsoon. Fiscal stress, given the failures on fiscal reforms such as state VAT and removal of exemptions, could impact public services in a number of states. RBI could hit a rough patch, and we could have trouble out of the inherent tensions in the combination of the currency market, the bond market, and the interest rate risk of banks.

At the same time, there is a serious possibility of extremely good outcomes shaping up. The central issue is investment demand: if capital goods expenditures grow well in 2004, then we can be on course for high GDP growth in 2004-05. There are signs that this could happen.

Ila Patnaik