The outlook on output’s pretty good

After the global financial crisis, potential output suffered a setback in most parts of the world. The underlying cause of the decline in potential output in the developed countries, inter alia , was the collapse of total factor productivity (TFP). For the emerging market and developing economies (EMDEs), this is mainly attributed to a slowdown in investment while the adverse impact on TFP has been modest.

India’s potential output and the corresponding output gap — the difference between what the economy is producing and what it can produce — are extremely important for policymaking.

This has become more important in terms of the new GDP series. India’s potential output has come down to around 7 per cent in the post-crisis period, compared to about 8 per cent during 2003-2008, according to an RBI study earlier this year led by this writer jointly with Harendra Behera (RBI Working Paper Series No. 5 of April 2016). The setback to India’s potential output was explained in terms of significant decline in investment during the recent years, besides some moderation in TFP.

The question that is being asked is simple: Is this a demand-side problem or a supply-side problem?

In India, urban demand has been more or less sustained. Rural demand, which was well above the trend for quite some time, moderated recently following growth slowdown in the agricultural sector due to two consecutive years of a deficient monsoon.

Despite several initiatives taken by the Government in the last two years, private investment is yet to pick up.

Capacity utilisation in the organised manufacturing sector at 71 per cent is one of the lowest in the last two decades. The crowding-in of private sector investment is yet to materialise despite large capital expenditure by the Centre.

What is holding back private investment? Is it global uncertainties or excess domestic capacity or both? In the aftermath of the global financial crisis, the economic recovery was policy-driven rather than market-driven. Growth in the world trade volume/value remained below GDP growth rates. Despite the ultra-accommodative monetary policy pursued by the developed countries, there is hesitant recovery in most parts of the world after nine years of the global financial crisis.

Financial flows to the EMDEs have been volatile, impacting financial markets adversely in those countries. Global uncertainties have dented investors’ confidence, particularly in the developing countries. The secular stagnation in developed countries has spilled over to the EMDEs. The slowdown in China has further complicated growth uncertainty in the world in general and in the Asia Pacific region in particular. The EMDEs have entered into a phase of low growth, low savings and low investment trap.

Breaking this vicious circle is a daunting task unless structural reforms are undertaken on a priority basis. Global demand is unlikely to accelerate in the near future as the global growth outlook remains sluggish despite a modest recovery in the US economy.

The Euro Zone continues to struggle for sustained recovery. Brexit further weakens the prospects of growth in developed countries. The Japanese economy is yet to respond in a convincing manner despite several policy initiatives taken by the government and the central bank after the crisis. Rebalancing of the Chinese economy is perceived as a significant headwind in the short run for EMDEs.

Hence, one would not expect export-led growth in India in the near future although export growth has turned positive in recent months.

That leaves the question of domestic excess capacity. A good monsoon this year will augment rural demand. Urban demand will get a boost due to a pay revision for government employees according to the Seventh Pay Commission and one-rank-one-pension for retired defence personnel. As demand is likely to improve, the slack in the economy may decline and capacity utilisation may increase in the near future. Yet, this has so far not led to any sign of improvement in private investment. In case private investment does not pick up, can we grow at a higher rate? Under these circumstances, is there a chance for India to move in the same direction of China, which is rebalancing from an investment-driven to a consumption-driven economy?

Many writers, for the first time, believe that the Seventh Pay Commission award is growth-positive. Sooner or later, India will have to improve its TFP so that higher growth is feasible with the same level of domestic capital formation. While public investment by the Government would help in this endeavour, existing excess capacity would meet, at least for some time, the growing consumption demand for a host of commodities such as FMCG, housing, white goods and so on.

The new generation of young people, once employed, can steer the growth impulse through consumption rather than through savings. Therefore, a better option to accelerate growth is to increase productivity rather than anticipate a higher level of investment. This does not mean investment should be ignored. One would expect higher growth with the same level of domestic capital formation even in a situation of stagnant savings provided TFP improves, thereby raising the potential output to the pre-crisis level.

The investment climate in India is much better today than it was a few years ago. Foreign direct investment is accelerating. Foreign investors see India as a preferred investment destination. The Government is committed not only to fiscal consolidation but also to structural reforms, both in the factor market and the product market.

The Goods and Services Tax, the opening up of the economy, financial inclusion and a whole host of reforms initiatives by the Government can transform the economy in a big way in the next two to three years. A combination of right policies, at the right time, even in an atmosphere of adverse global developments, can insulate the economy from global uncertainties.

India’s potential output is poised for improvement, mainly driven by structural reforms by the Government. If the negative output gap persists, the RBI may continue with an accommodative monetary policy for some more time, provided the CPI inflation stays under control.

The writer was principal adviser to the monetary policy department, RBI. Syndicated by The Billion Press

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