Mind the output gap PDF Print E-mail
Saturday, 30 April 2016 00:00
AddThis Social Bookmark Button

RBI puts India’s potential output growth at 7%


Given the likelihood of a good monsoon, chances are GDP growth this year could be in the 8% range. A recent working paper by two RBI staffers, however, suggests caution since the economy’s growth potential has also declined, to around 7% right now. That means, over the medium-term, India cannot hope to achieve a GDP growth that is significantly higher than the present one without triggering off a sustained period of inflation. Potential output, like the incremental capital output ratio (ICOR), of course, is not something that holds over short periods of time. So, an ICOR of 4, India’s historical average over decades, doesn’t mean that GDP will grow at 9% in a year when investment levels are 36% and fall to 8% if the levels fall to 32%—it is an approximation that holds true over a period of time. So, if the potential output falls, chances are so will the non-inflationary GDP growth.

Thanks largely to a fall in investment in capital goods, the RBI staffers point out—using a variety of sophisticated econometric tools to test their hypotheses—India’s potential output has fallen to around 7% right now. Potential output rose from around 5% in 1981-91 to around 6% in 1992-2002 and then rose further to 8% in the 2003-08 period. Apart from the hike in local investment which was made possible through higher savings in 2003-08, what also helped was the global trade boom that, in turn, fuelled the domestic investment boom. Equally important, the investment boom which was fed by a savings boom was driven by the huge turnaround in government savings as well as corporate savings that also rose dramatically.

With global export conditions unlikely to be picking up for the next few years at least, especially with Chinese growth prospects getting worse all the time, any significant export boost to India’s economy is unlikely. Given the lower potential output, that means if India’s GDP growth is to pick up in a sustained manner, the only way to do that is to either increase capital investment levels or find ways to increase both labour and capital productivity—both require a significant step up in reforms as compared to what’s happening today. Indeed, given the over-leveraged nature of India Inc and the shape the bank balance sheets are in, even if the pace of reforms were to pick up, it would take a few years for the investment cycle to reignite. For a government that has come to power on the promise of higher growth, that can’t be good news.

Last Updated ( Monday, 02 May 2016 03:44 )

You are here  : Home Economy Mind the output gap