A new focus for policy

Financial Express, 23rd June 2012

In recent days, we have often heard politicians taking pride in the fact that India is still among the fastest-growing economies in the world. Even if India grows at 5% next year, it will still be one of the fastest-growing economies in the world, and yet it may be said that it is in the depth of a recession. So which of the two statements is true? Is India a fast-growing healthy economy, or is India facing a business cycle downturn?

The answer to what is apparently an inconsistency lies in the faster potential growth rate of emerging economies like India. Business cycles are studied in relation to the potential growth rate of an economy. One simple way to understand this is that the growth of the labour force in a country largely determines the potential growth rate. If GDP grows at 5%, if employment growth is slower than the growth rate of the labour force, the economy is operating below its potential growth rate and has an output gap.

Business cycles in emerging economies are different from those in developed countries. The key difference is that output, consumption and investment are more volatile in emerging economies. In advanced economies the framework of fiscal and monetary policy seek to stabilise the cycle, financial sector development, trade and capital account openness and access to finance are mainly responsible for the smoother cycles and lower volatility in emerging economies.

In a paper on business cycles in India titled "Has India emerged: Business cycle stylised facts from a transitioning economy", my co-authors Chetan Ghate, Radhika Pandey and I study how business cycles in India have changed since the liberalisation of 1991. We find that in the pre-reform period the volatility of output, consumption and investment in India was far higher than in advanced economies and the economy looked like other emerging and developing economies which witness high volatility. In the period after the reform, we find that the economy witnessed a decline in volatility and the stylised facts of the post-liberalisation business cycles in India start looking, in many ways, like those of advanced economies.

A number of reasons could have caused the change. Our key result is that the reduction in volatility has come about not due to "good luck", but due to a structural change of the economy. "Good luck" would have meant that the economy faced smaller exogenous shocks in this period. We show that when we look at either the variability of oil prices, or the shocks to total factor productivity (TFP), the variability was not lower in the post-reform period than in the pre-reform period. This supports the hypothesis that it was the change in the structure of the economy, rather than lower exogenous shocks, that resulted in the decline in volatility.

The opening up of the economy on both the current and capital account can allow an economy to smooth out its consumption, investment and output. For instance, when there is a shortfall in the production of a raw material, its imports can make it possible for the economy to continue to produce the good that requires it. Similarly, if savings are low and interest rates are high, then if the capital account is open, the country will attract capital and the availability of capital will increase, allowing the investment to GDP ratio to be higher than the saving to GDP ratio.

The question of whether the opening up of an economy makes it more or less vulnerable to greater shocks has been much debated. Our evidence shows that in the period when the Indian economy opened up, then even though the volatility of oil prices and TFP shocks to the economy were higher than before, the economy witnesses lower volatility in its business cycles. In the international literature, cross-country evidence suggests that countries benefit, in terms of lower volatility of macroeconomic variables, from opening up their capital accounts (there is broad consensus that opening up the trade account is good for all), only after reaching a certain threshold level of development of domestic financial markets.

Another major finding of the paper relates to the change in the nature of business cycles in India. The share of agriculture in India’s GDP has fallen from 53% in 1951 to 15%. So the variability in agriculture does not affect GDP as much as it did in earlier years. Further, agriculture is not as dependent on monsoons as it was earlier. Thus, even the volatility of agricultural output is lower than what it was. While earlier economic cycles in India were mainly caused by shocks to agriculture, today they are caused by investment inventory cycles.

The share of investment in GDP has increased from 13% in 1950-51 to 35% in 2009-10. The increase has been particularly prominent since 2004-05. In the investment boom of the mid-1990s, private corporate gross capital formation rose from 5% of GDP in 1990-91 to 11% of GDP in 1995-96. It then fell dramatically in the business cycle downturn to 5.39% in 2001-02, and then recovered to 17.6% in 2007-08. The recent recession has led to its fall to 13.5% in 2009-10. It has declined further since then.

This study has important implications for policymaking in India. It lays the ground for a case for counter-cyclical fiscal and monetary policy. Macroeconomic stabilisation has not been the basis of the framework for policymaking in India. This needs to change as it will allow us to stabilise consumption and output further. In the present environment, macroeconomic policies will be particularly difficult as India is facing a stagflationary environment, with an output gap and inflation higher than the inflation rate that the economy is comfortable with. Knee-jerk policy responses to monthly announcements of the IIP or WPI do not offer a meaningful framework for macroeconomic policy making in India today. Institutional changes such as those which aim to give the monetary authority independence and accountability and a framework for fiscal stabilisation are as important, if not more, than reform measures like FDI limits and insurance caps.

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