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Monday, Nov 10, 2003

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Chimera of economic pre-eminence

Ranabir Ray Choudhury

All set for the quantum leap? A recent Goldman-Sachs report predicts that, given the `right conditions', the Indian economy could become larger than that of Japan by 2032.

FIVE WEEKS ago, Goldman Sachs dropped a bombshell when it suggested in one of its periodic global papers that the BRIC countries (Brazil, Russia, India and China) were poised to take on the economic leadership of the world, displacing in the process economies like those of the US, Japan, Germany, France, Britain and Italy (the G-6 in short) in 50 years.

The ripples made by the report are still being felt, which is nothing unusual given the entrenched place in the human psyche which the traditionally developed countries occupy — not just now but ever since the close of middle of the 19th Century when unbridled colonial exploitation by the imperialist powers established their economic stranglehold over the global economy.

But the all-important question is: Although it would be welcome to believe that the Goldman Sachs conclusions do portray real trends and developments in the international economic sphere, how reliable are they?

First, what does the report set out to do? As it says right at the beginning, the effort is to highlight "the importance of thinking about the developing world" in the firm's recent global research, "focussing on key features of development and globalisation that we think are important to investors with a long-term perspective".

The major theme of the report is that, "over the next few decades, the growth generated by the large developing countries" — that is, the BRIC economies — "could become a much larger force in the world economy than it is now — and much larger than many investors currently expect".

Among other things, the shape of the future could be as follows: The Indian economy could, for instance, become larger than that of Japan by 2032, and China could overtake the US by 2041. In fact, the computation suggests that China will overtake every economy accept the US by 2016.

The methodology of the calculations is not very complex. The report not only extrapolates current growth rates in the BRIC economies but also sets out "clear assumptions about how the process of growth and development works" and also by "applying a formal framework to generate long-term forecasts".

It uses the latest population projections "and a model of capital accumulation and productivity growth" with which to plot GDP growth, income per capita and currency movements in the BRIC countries.

The introduction of "assumptions" makes it clear that there is nothing foolproof about the conclusions; specifically, that there is a reasonable chance of the estimates going awry on account of the chosen assumptions failing to work out as expected.

As far as the report itself is concerned, the point is conceded that the conclusions are "optimistic" in that they assume "reasonably successful development". But as regards the specific economic content, it is stated that the projections are "sensible, internally consistent and provide a clear benchmark against which investors can set their expectations".

Very sensibly, and thereby enhancing the intrinsic value of the effort, it is admitted that the "right conditions" may not prevail in one economy or the other and that, consequently, the projections "will not be realised". This apart, the report says that "history also illustrates that any kind of long-term projection is subject to a great deal of uncertainty. The further ahead into the future you look, the more uncertain things become".

While such emphasis is welcome, there is little by way of a firm indication on the possibility or otherwise of the BRIC economies deviating from the path of following sound, "growth-supportive policies", which would have been a valuable input in the decision-making process of long-term investors who follow the advice of firms like Goldman Sachs. (After all, as the report says: "Over 80 per cent of the value generated by the world's major equity markets will come from earnings delivered more than 10 years away".)

Instead, the report has recourse to sentences like: "If the BRIC group pursues sound policies...the world we envisage here might turn out to be a reality, not just a dream". Or, "the projections leave us in no doubt that the progress of BRIC will be critical to how the world economy evolves. If these economies can fulfil their potential for growth, they could become a dominant force in generating spending growth over the next few decades".

Even so, on balance, what are the chances of the BRIC economies being true to the projections made by the Goldman Sachs report? The first point, which the report indirectly hints at, is one based on the observation of historical developments.

It says that over a period of "a few decades, the world economy can change a lot", and that this is borne out by the history of economic change at the country level over the past 30 to 50 years.

The cases of Japan, Germany, China and Korea have been cited as instances of how the economic underdog can effectively challenge the might of the ruling economic powers and carve out for themselves a niche in the international economic firmament.

Three other points have been suggested which indicate that the road ahead for the BRIC economies is potentially one towards higher economic growth.

The first among these argues that the developing countries of today "have less capital (per worker) than developed economies", which means that, in normal circumstances, returns on capital will tend to be higher than in a situation where capital use is at a higher level (like in developed economies).

What this, in turn, means is that a "given investment rate results in higher growth in the capital stock", or, in other words, the return on capital in the BRIC economies will be systemically higher than that in the G-6, for example. The second point is that the BRIC countries can use technologies available in developed economies "to `catch up' with developed country techniques".

The problem with this specific argument is that, as yet, there is no conclusive evidence that the return on technology as an input is diminishing, in the sense it is so with labour and capital. If this is so, it cannot be argued with any firmness that, secularly, the developed economies are facing a diminishing returns curve vis--vis the use of technology. The upshot of this is that the returns from the use of technology in the BRIC economies and in the G6 are more or less equated to each other, the rate of return being governed more directly by the state of the technology used, a sphere where the G6 still has an big advantage over its poorer brethren.

The third point is that, per se, countries tend to grow richer "on the back of appreciating currencies", the latter in turn climbing "as higher productivity leads economies to converge on Purchasing Power Parity (PPP) exchange rates". The scope of currencies appreciating is larger in the BRIC economies because of the existing gap between their actual exchange rates and their PPP, which is not the case with higher income per capita countries (the G-6, for example).

As the reports states: "These large differences between PPP and actual exchange rates come about because productivity levels are much lower in developing economies. As they develop and productivity rises, there will be a tendency for their currencies to rise towards PPP". Finally, what should the BRIC economies do to keep their actual performance in the years ahead on track vis-a-vis the report's projections (that is, what should the "right conditions" be)?

Four have been shortlisted, namely: Sound macro-economic policies and a stable macro-economic background; strong and stable political institutions; openness; and high levels of education.

None of these conditions is novel in the sense that they have not been talked about before which, curiously, injects a sense of inevitability into the Goldman Sachs projections. The message to the BRIC economies could well be: Just do what you are doing, and you will be in front of the pack with the passage of time. God bless our grandchildren.

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