Indian Economy - Not Overheating

There is abundant evidence that the Indian economy is not overheating. So stop the presses from broadcasting this now absurd conclusion.

Several international and domestic economists, policymakers, and journalists, and including prominently The Economist, offer one explanation after another to justify their predetermined, ideological (?) and/or confused conclusion that the Indian economy is overheating, and/or that the rupee is mismanaged (read that it should be allowed to appreciate). The list of distinguished economists (both Indian and foreign) within and outside India is large; can they all individually and collectively be in error? I believe so; so bear with me as I go through the arguments offered. At the end, you can’t take both sides and conclude everybody is right; one view is “right”, the other “wrong” even within the bounds of two-handed economics and multi-faced research.

So here goes. First, what does overheating mean? For most honest brokers, it means an unsustainably high rate of acceleration in economic growth. How does one know that the acceleration is unsustainable? By noting that the rate of inflation has also increased to a high and undesirable (even if sustainable) level. There is a third parameter—trade deficit—whose pattern can also reveal overheating. However, the trade deficit may indicate other factors at work, most importantly the exchange rate. Ordinarily, a rising trade deficit can indicate overheating, but this is often misleading. For example, if one went by the rising trade deficit view, one would be forced to conclude that the US economy was overheating, even as it accelerated to a growth rate below 2 per cent per annum. And, equivalently, one would be forced to conclude that the Chinese economy was spiralling towards a recession as its trade surplus reached beyond 10 per cent of GDP.

Analogously, the rate of growth of credit expansion can also be misleading—it can either mean an overheating economy or an economy moving towards a higher growth path, or an economy becoming more monetised (more transactions in the formal sector). Perhaps the least useful indicator of anything, let alone overheating, is the rate of growth of money supply. In a closed economy, it had meaning, but even the wisest of the overheating aficionados acknowledge that India is not the closed economy it was five years ago, let alone the super-closed economy it was in the late 1980s.

There are three major determinants of growth—investment (capital), labour, and productivity. While the growth rate of employment has accelerated to a long-run average of now close to 2.5 per cent per annum, the unemployment rate has not budged, as labour force growth has also increased to this average (powered by increases in the labour force participation rate of urban women). So no signs of overheating here. Just five years ago, India was saving and investing about 23 per cent of GDP. Since then, the savings rate has increased by at least 10 percentage points and in 2005-06 was more than 32 per cent of GDP and in 2006-07 is likely above 34 per cent (Prime Minister Manmohan Singh, please note: If conspicuousness has increased, it is in the arena of negative consumption, i.e. savings).

But savings do not determine growth, investment does. And the rate of investment is close to 36 per cent plus of GDP, up some 13 percentage points over just a few years ago. This translates into a rate of growth of capital of 10 per cent per annum, compared to a 5 per cent growth rate before. Not too many of the sceptical growth experts have argued, either, that this increase in investment is a spike and therefore unsustainable, nor have they argued that increased investment financed mostly by increased savings is a sign of overheating (not yet, anyway, but who knows what they will say in order to “save” their ideological beliefs).

Simple and conservative calculations suggest that these extra inputs into production will yield an extra growth rate of 2.8 per cent per annum. Take almost any time-period post 1980 and India’s GDP growth rate has been close to 5.6 per cent. Thus, one reaches the conservative conclusion that the expected, sustainable, non-inflationary GDP growth rate in India is 5.6 + 2.8 = 8.4 per cent per annum. These calculations do not factor in the increased productivity growth that comes in from a step jump in investment spending. This is easily at least 1 per cent per annum. So look out for GDP growth above 9.4 per cent to even begin thinking about an overheating India. And forget 7 or even 8 per cent per annum as the non-inflationary trend rate of growth.

What about all the extra inflation, the other favourite of the (confused) naysayers and/or the present government? Isn’t the high inflation we are experiencing a sign of an overheated economy? There are several indicators of inflation available, and one can choose the consumer price index to make the point that for a brief period, supply-side factors (a steep increase in the price of cereals and oil) did cause the inflation rate to jump by 2 percentage points. But these indicators are outdated (in terms of “base” year) and restricted (only sample either industrial workers, or agricultural workers). The GDP deflator is an accurate indicator of trends in inflation. Since 2003, this indicator has not wavered much beyond 4.3 per cent per annum, and in the last problematic year (2006) registered 4.6 per cent. This trend is supported by the WPI—an inflation rate in 2006 equal to that in 2005 at 4.7 per cent per annum. So far this calendar year, seasonally adjusted inflation is running at a 3.5 per cent rate. Overheating, anyone?

Given this freely available data and reality, why do the overheating protagonists blissfully parrot this grossly inaccurate line? Does the hugely increased investment spending not add to any extra GDP growth? As a forecaster, one should always remind people of when one is right—and quietly change one’s opinion when one is wrong. Some quotes of Keynes that will help those in error to correct themselves. “It is better to be roughly right than precisely wrong”. Or “there is no harm in being sometimes wrong—especially if one is promptly found out” and finally, “when facts change, I change my mind. And what do you do, Sir?”