Inflation is the tip of the iceberg

It has become commonplace to see many senior government officials confidently predict a double-digit growth rate for the Indian economy in the near future. They must exhale. India is not ready for it yet, not based on what they have done in the last six years. It is not impossible, but they must work at it.

The Asian obsession with growth
There are many reasons for India to pursue a high growth rate. One, China’s growth rate continues to remain high and is a source of pride for that nation and admiration for the rest of the world. Two, not just China, but all of the East Asian ‘Tiger economies’ were, at one stage or the other, fast-growing economies. So, if one were an Asian nation, then one has to grow fast. Growth has become an obsession with many states—big or small. India is proving to be no exception.

You might take exception to the tone of the previous paragraph. It suggests disapproval. After all, for years, economists were hoping and wishing that India would focus attention on growth rather than on distribution because without growth, there is nothing to distribute. One cannot ferret stuff out of an empty vessel. Now that the Indian State is setting its sights on growth, we are back to criticising it. Cannot they ever get it right? Prima facie, this exasperation appears justified. But not much beyond that.

There are two aspects to any growth objective. One is not to deviate too far from the potential growth rate as it stands—neither too much below nor too much above it for too long. The other is to keep improving the potential growth rate of the economy. Currently, the Indian government’s growth strategy is failing on both counts. Well, at least, until very recently.

Estimate of potential growth is between 7-8 percent
In an IMF working paper published in 2004, Dani Rodrik and Arvind Subramanian estimated that an annual GDP growth rate of 7 percent was easily achievable. The implicit assumption was that such growth would a sustainable, without upward pressure on prices. In its annual report for the year ending June 2009, the Reserve Bank of India estimated India’s potential GDP growth to be around 8 percent and attributed it to “investment spurt and reform related productivity gains.” There was no substantiation of these causal factors.

India achieved an average growth rate of 7 percent this decade, with the five years up to March 2008 generating an average growth rate of 9 percent. It was partly due to an increase in corporate and public sector savings because, on paper, the government’s fiscal deficit shrunk in that period despite a massive expansion in public entitlement programmes. However, global commodity prices rose, domestic wages rose and the inflation rate spiked up in 2007-08 before the global crisis brought both growth and inflation down in 2008-09.

Persistent rise in cost of living exposes growth ceiling
If the sustainable growth rate of the economy was 8 percent according to RBI, targeting a growth rate of 9 percent or above is an invitation for a rise in prices. That is what is happening now in India. Despite the attempt to pass off the spike in prices as food and agriculture related, non-food inflation is running at a rate of above 7 percent. Overall inflation, as indicated by official consumer price indices with all their flaws, has been running well above 10 percent for quite some time now.

Despite the fact that economic growth up to 2008 was driven by gross fixed capital formation and that it was accompanied by an improvement in government’s fiscal balance in that period, the spike in the inflation rate and its persistence confirm that capital formation did not alleviate India’s supply bottlenecks. New capacity was not added and existing capacity was not better utilised.

Decelerating output growth in infrastructure industries
Output in the six infrastructure industries—electricity, coal, finished steel, cement, crude petroleum and petroleum refinery products—registered noticeably slower growth in 2007-08 and 2008-09. In particular, generation of electricity—the key ingredient for all sectors—has been rather worryingly poor in the Eleventh Plan period (2007-12). According to RBI’s annual report 2008-09, the deficit in power supply has expanded from 8.5 percent in 1992 to 12 percent in 2008-09.

Narrowing this down further, thermal electricity generation was around two-thirds of the target during the Tenth Plan period. In the first two years of the Eleventh Plan Period, it was a meagre 16.2 percent. The shortfall was starker in 2008-09 with capacity addition being a pitiful 4.4 percent of the target. In other words, India is not yet capable of achieving a growth rate of above 8 percent in a sustainable, non-inflationary manner. Further, there has been a shortfall in the targeted capacity addition for electric power both in the Tenth and in the Eleventh Plan periods.

The annual compounded growth rate in the output of the six infrastructure industries was 6.7 percent during the five-year period ending March 2008. It was at a time when the Indian economy grew at a rate of 9 percent. The mismatch has only worsened further. The trailing annual growth rate in the output of these industries for the five-year period ending March 2010 has further decelerated to little over 5 percent now. This places a cap on sustainable growth that the economy can achieve.

Credit: David Trattnig

Coveting both quantum and quality of economic growth
This worrisome state of affairs in the hard infrastructure areas is matched by gaps in soft infrastructure such as education and supply of skilled labour. While the government appears keen, in principle, on bringing about a drastic change in the manner in which the poor children are educated, it is still seeking to achieve it through the agency of government, for the most part. The failure of government schools in education is well-documented and is a feature of many developing countries in Asia and Africa, with the exception of China.

Private schools that are currently stepping into the breach in the education of poor children are now at a risk of being de-licensed within a certain period, if they fail to provide the infrastructure that is expected of a school. It would be wiser to require these private schools to tie up with bigger government schools or colleges for a fee, to provide the children the facilities they lack.

This was done in Tamil Nadu when the government introduced the 10+2 system in 1978. Many schools did not have laboratories required for pre-university students. They formed clusters and each cluster was attached to a college that, in turn, provided laboratory facilities to the schools in that cluster.

As for the Indian labour market, the implicit assumption that the demographic dividend would automatically help to deliver a growth rate of 9 percent or more might turn out to be misplaced for the long-term as it is, for the present. In their latest annual report on the labour market, TeamLease, a staffing company, and Indian Institute of Job Training, a vocation training provider, cover in detail the mismatches in education, geography and sectors between what employers want and what India’s labour pool has to offer either now or in the future, based on continuation of current trends.

According to the report, while 12.8 million people enter the labour force every year, training capacity exists only for 3.1 million. Only one in ten of the 12.8 million had any vocational training and only one in a hundred had formal vocational training.

An uneducated and unprepared labour force is a cost to employer and not a source of productivity and innovation. Hence, India’s demography, far from delivering a growth dividend, could drag it lower, if nothing is done about the issues the report raises, in the next five years

To keep face, government steps in
Let us be clear. These lacunae do not weaken India’s case for a high growth rate. An annual growth rate of 8 percent is very respectable these days. India’s high savings rate and better capital efficiency will ensure this outcome with little difficulty. However, instead of settling for it, and at the same time working on enhancing the economy’s growth potential, the government is likely to take it upon itself to propel such growth through government expenditure geared towards re-distributive policies.

Apparently, the Sonia Gandhi-led National Advisory Council has approved the Food Security Act with the aim of delivering 35 kg of grain per month at Rs 3 per kg to every family in the 200 poorest districts, extendable, as feasible, to other districts, and providing 25 kg per month to families that aren’t poor. The extension of the Food Security Act to the well-off boggles the mind.

This will raise regular market prices. The supply ostensibly diverted to the Public Distribution System will find its way back into the open market only to be sold at higher prices. The implementation of the Act will increase inflation and thus leave the poor more impoverished. In the meantime, the higher subsidy outgo will count towards economic growth with neither equity nor efficiency achieved.

Instead, the government should add to and follow through on its recent initiatives in energy pricing, national litigation and land titling with reforms in education, agriculture, labour market and more importantly, in governance.

India needs both high growth and high-quality growth. If the government were intent on only delivering the former now, in future, India would enjoy neither. We need to be asking a lot of questions of the government now rather than later.

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