Costly mistake

Indian Express, 20 February 2012

The growth rate of India's GDP has declined to below 7 percent per annum. When in 2008, GDP growth in India did not fall sharply as it did in the US, the epicentre of the global financial crisis, we hoped that India had escaped the crisis. But the growth in production has fallen slowly, and with a lag. However, the downswing of the cycle around the trend line, is now showing signs of persistence. Further, the lack of macroeconomic stabilisation policies imply that we may not be able to engineer the kind of sharp upturn in economic growth that the US economy appears to be currently witnessing.

The GDP growth estimate for 2011-12 has been revised downwards to 6.9 percent. This means that growth has declined from the 9.6 percent witnessed before the global financial crisis by 2.7 percentage points. Even though this growth rate is amongst the highest in the world, what matters to us that this growth may be below our potential growth.

If the long term trend growth rate of the Indian economy is about 7 to 7.25 percent then growth has now slipped below trend. The cyclical downturn should be seen in the context of the difference between advanced economy business cycles and emerging economy business cycles. In advanced economies like the US the trend growth rate is very low, nearly zero, and therefore a business cycle is an actual fall in production. In a recession GDP growth rate turns negative. In emerging economies trend growth is positive. A business cycle downturn can be viewed as fall in the growth rate of GDP around a trend line. Since the 1991 liberalisation India has witnessed cycles around a trend growth rate, as observed in growth cycles in other emerging economies.

The biggest cause of the decline in GDP growth in India has been the decline in private sector investment. When in September 2008 the global crisis hit the world, difficulties in obtaining credit and a decline in the confidence led to a sharp fall in private corporate investment. In the years preceeding the crisis, gross fixed capital formation of the private corporate sector had been growing rapidly at nearly 30 percent per annum since 2005. In 2008-09 the growth of private corporate gross fixed capital formation became negative and fell sharply by 22 percent. The decline was in both components of private corporate investment i.e construction and in machinery and equipment. In construction private investment declined by 48 percent, and in machinery and equipment by 12 percent. In the following year, investment appeared to recover, and rose by 15 percent. This was a recovery to the pre-crisis levels of investment, and not really a rise, but, unfortunately it gave a sense of false complacency to policy makers.

Data on investment projects suggests that in 2009 investment was mostly in projects that were being already under implementation. These might have faced difficulties in the 2008 crisis and were now back on track. However, with greater uncertainty in the world there was a decline in new projects being announced. This fact is reflected in the growth of private corporate investment in 2010-11, which grew at a mere 4.7 percent. That year GDP growth was at 8.4 percent. The low investment growth should have set alarm bells ringing. Interest rates, even in nominal terms, were not high or biting. The data for private corporate investment is not available in the estimates published by CSO for 2011-12 yet, but it is likely that its growth fell further, as both GDP growth fell to 6.9 percent and new investment projects announced did not see an increase.

Macroeconomic policies, such as fiscal and monetary policies, have been unable to play an effective stabilisation role in this downturn. In general, macroeconomic stabilisation policies are expected to be countercylical policies. So when the economy is expected to slow down the government can give a fiscal stimulus. Data shows that while in the post crisis period we did see an expansion in the growth of government consumption expenditure, it was accompanied by a decline in public investment. Growth in gross fixed capital formation by the government fell from annual growth rates over more than 15 percent in the pre-crisis period to 12 percent in 2008 and 2009 and even further to 5 and 6 percent in the last two years. The main difficulty in giving a fiscal stimulus was the already high level of fiscal deficit. In the good years from 2004 - 2007 there had been no serious attempt at fiscal consolidation. If the government does not tighten its belt with times are good, then it does not have the space to give a stimulus when times are bad.

Similarly, the period of low inflation in the pre-crisis period could have been one of the best times to move to an inflation targeting framework. The central bank could have earned credibility and low inflation. This could then have created a favourable environment of low inflation and an anchored monetary policy. Instead, in the pre-crisis years the RBI spent all its energy on preventing rupee appreciation where actually an appreciation could have been an effective countercyclical montary policy preventing overheating and keeping the price of tradables low. This mistake proved costly once the crisis hit. High liquidity generated from years of partial sterilization of the rupee, along with the lack of a nominal anchor and a sharp rupee depreciation resulted in the buildup of inflationary pressures in the economy. The RBI is still grappling with the consequences of its mistakes in the pre-crisis years.

It is unlikely that the GDP growth cycle will turn around very soon. In the long run India remains a high growth economy. However, along with high growth we may have to live with high volatility of growth and inflation unless we can adopt a credible framework for macroeconomic stabilisation policies.

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