India booming: cyclical or sustainable?

Indian GDP growth has averaged 8% for four years. Indeed, it has crossed 9% in the first half of this fiscal year. The updated BRIC report of Goldman Sachs claims that India can sustain 8% growth for over a decade.

Now, a few years ago India seemed stuck in a growth groove of 6% per year. Many analysts said it could not accelerate without much more reform. However, despite few new reforms, growth is up to 8%. Is this just a cyclical upswing, with India riding a global wave that will soon ebb? Or has something changed fundamentally?

The cyclical argument is strong. Earlier, when India grew at 6%, sub-Saharan Africa grew at 3.5%. So, India used to beat Africa by 2.5% per year. But in the last three years, a global growth boom has lifted GDP in most developing countries by an average of two percentage points. African growth is up to 5.5%. So, Indian growth of 8% is still only 2.5% higher than Africa’s, the same as in earlier times. This could mean that a global tide lifting all boats, and a downswing could take India back to 6% growth.

However, a strong case can also be made that the cumulative effects of Indian reforms over since 1991 have reached a tipping point that has pushed India into a virtuous cycle of higher growth and savings. For a long time after the 1991 reforms, Indian GDP growth averaged only 6% or so, not much higher than in the 1980s. Arguably, the cumulative effects of reform have finally reached critical mass, and hence exploded into much faster growth. If the tipping point thesis is right, so, India will be affected only temporarily by a global slowdown, and will soon resume 8% growth.

What is the virtuous cycle we are talking about? When GDP growth accelerates, consumption rises slower than GDP: people are cautious about accelerating their consumption. Hence the savings rate rises sharply. This depresses interest rates and encourages fresh investment, which in turn facilitates fast growth, in a virtuous cycle. China entered this virtuous cycle in the 1980s, and India seems to have done so since 2004. When Indian GDP growth accelerated from 6% to 8%, the savings rate increased from around 25% to 30%, and economist Surjit Bhalla argues that it is much higher this year. Higher savings facilitate higher investment, and hence sustain fast growth. So, the tipping point may have sent India into a permanently higher growth path.

I have long bemoaned the slow pace of reforms. We see no reform of the arms of governance: the judiciary, administration and police. We see no reform of educational or health services. Labour reforms remain politically impossible. Almost 330 items are still reserved for small scale industries.

But Arvind Virmani, Principal Advisor to the Planning Commission, has drawn my attention to a slim volume he produced back in 1999 listing various second-generation reforms that were needed. Reading through that, I realized that very substantial second-generation reforms had indeed been implemented in bits and pieces. The Fiscal Responsibility and Budget Management Acts of the central and state governments have reduced the overall fiscal deficit from around 10% to perhaps 6%, and once-bankrupt states now have cash surpluses of Rs 25,000 crore.

Import duties have been brought down to ASEAN levels (around 8%) for most items, creating a healthy competitive environment. Bank reforms have liberalized interest rates, slashed non-performing loans, and helped banks move towards Basel-2 norms. Agricultural barriers such as the Agricultural Produce Marketing Committees Act have been eroded if not abolished in many states, paving the way for corporates to buy produce directly from farmers, cutting out intermediaries and creating a retail revolution. Telecom reforms have sparked a revolution: India has the lowest tariffs in the world and 7 million new connections per month are being sold. The latest telecom reforms will facilitate penetration of rural areas by private players.

The electricity sector has witnessed slow, halting reform, but open access in now a reality, and the new bidding process for ultra-mega power plants has brought in power at the once-unthinkably low price of Rs 1.19 per unit. Model agreements have facilitated infrastructure deals. The Railways are in surplus, have privatized container traffic, and are planning two dedicated freight corridors to speed up traffic. Bharat Nirman is finally bringing infrastructure to rural India. The states have introduced a VAT to replace sales tax, and the country is moving towards a universal Goods and Services Tax. Tax administration has been computerized and is bringing in much more revenue. The old fiscal discrimination against mill-made textiles has gone, and the number of items reserved for small scale industries has been pruned from 880 to 326.

There remains a substantial unfinished agenda. Reform has been reversed in areas such as price controls for petroleum products and pharamecuticals, directed lending for agriculture, and free power for farmers. Still, Virmani is right in saying that a very wide range of reforms have indeed taken place. This strengthens the tipping-point thesis. India was always going to reap the rewards of reform at some point, and that time is now.

What could go wrong? Will high growth induce high inflation that erodes the virtuous cycle? Wholesale prices are up 6%, and consumer prices are up over 10% in north India, largely because wheat prices are up 17%. Will the RBI to raise interest rates and check growth to cool prices? Will inflation be the Achilles heel of the Indian growth story?

I doubt it. The yield on 10-year treasuries is still very low at 7.5%. The virtuous cycle of growth has produced a glut of savings, both in India and globally, taming long-term interest rates, which are beyond the control of central banks.

Geopolitical threats remain. Terrorist attacks in the US or an Israeli attack on Iran could spark panic and market collapses. Yet, if the new virtuous cycle is a reality, geopolitical incidents will merely be blips in a larger growth story.

 

What do you think?