India’s Economy: Performances and Challenges S. Bhalla- Session III.pdf · India’s Economy: Performances and ... Some background facts about Indian economic growth ... Indian

India’s Economy: Performances and Challenges

Essays in Honour of Montek Singh Ahluwalia

Indian Economic Growth: Three Puzzles

1

Indian Economic Growth: Three Puzzles Presented by

Surjit S. Bhalla*

February 10th , 2010

*O[x]us Research & Investments, New DelhiEmail: [email protected]

The China-India Story – 1500 - 2025

(%) share in world population

2022

4050

Per

cent

per

yea

r

Lost in 450 years , gained in 45

2

China India (%) share in world output

1020

30 P

erce

nt p

er y

ear

1500 1600 1700 1800 1900 1980 2025Year

Source: Bhalla, Surjit S, Second Among Equals: The Middle Class Kingdoms of India and China, draft 2007; final draft(2010); forthcoming, Peterson Institute for International Economics, Washington, D.C.

Indian Economic Growth: Three Puzzles

� Three factors of growth, three major determinants – Capital,

labour and productivity

• Real Interest Rates (price of capital)

• Currency Undervaluation (price of labour)

3

• Middle Class (productivity)

� Some background facts about Indian economic growth

• Constancy of agricultural growth

•For most variables, constancy in various macro variables

(until 2003/2004)

Indian Growth Performance, 1980-2009

Total Factor Productivity Growth,

India-China, 1950-2007

Year Average(5 years) Average (20 years)

Growth Rank Growth Rank

1980 3.2 56 3.7 60

1985 5.4 19 4.1 35

China India

1950-1980 1.96 1.23

4

1985 5.4 19 4.1 35

1990 6.0 12 4.3 27

1995 5.2 28 4.9 17

2000 6.3 11 5.7 11

2005 7.0 7 6.1 6

2009 8.5 4 6.5 4

1980-2002 2.4 3.04

1950-2002 2.2 1.98

2003-2007 5.34 3.84

1950-2007 2.56 2.14

Evolution of Middle Class in India60

.080

.010

0.0

Mid

dle

Cla

ss(%

)

5

0.0

20.0

40.0

Mid

dle

Cla

ss(%

)

1960 1970 1980 1990 2000 2010 2020 2030Year

Note: Middle class line defined to be the weighted poverty line in the developed world; in 2010 rupees, this line is Rs. 150,000 for a family of four.

Agricultural Growth – Constant at 3 percent10

20P

erce

nt p

er y

ear

Constancy of Long Run Agricultural Growth in India

6

-20

-10

03

Per

cent

per

yea

r

1950 1960 1970 1980 1990 2000 2008Year

Hindu Constants and the Constancy of growth rate 1980-2002

Growth in

GDP Industrial Production M3 Share of Fiscal Deficit/GDP Real Interest Rates*

Decades

1950-59 3.3

1960-69 4.4 8.8

1970-79 2.9 4.0 17.4 -3.8

3 Year Averages

1980-82 5.6 4.6 16.1 -5.5 -3.3

7

1980-82 5.6 4.6 16.1 -5.5 -3.3

1983-85 5.6 8.0 17.5 -6.9 1.5

1986-88 6.4 8.4 17.4 -7.8 3.9

1989-92 4.3 5.6 17.6 -6.9 2.7

1993-95 5.9 5.1 17.4 -6.0 2.0

1996-98 6.1 8.6 16.2 -5.2 5.0

Data after the "India Decade" article

1999-01 5.9 5.2 17.8 -5.8 5.7

2001-03 5.8 5.2 15.4 -5.5 5.8

2004-07 9.1 9.1 17.9 -3.7 2.1

1992-95 6.2 7.1 17.0 -5.7 2.3

1997-03 5.3 4.8 17.3 -5.9 6.1

2003-07 8.9 8.7 17.0 -3.8 2.6

Note: * Defined as the difference between the weighted government securities rate and inflation as measured by the GDP deflator.

Puzzle 1: What caused India’s GDP growth to accelerate in the early 1980s?

� Conventional explanations:

• Bank nationalization led to higher savings rates

• Indira Gandhi winked at the industrialists and growth took off

� These explanations cannot be found in most economic text books; plus, in

reality, there wasn’tany acceleration.

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reality, there wasn’tany acceleration.

� But there was an appearanceof acceleration - the whole world had seen a

stagflation downturn in the 1970s, and India was not much different.

� Evidence:

•Reallocation of labor from agriculture to industry – movement from lower to

higher productivity

•Several instances when Indian GDP growth had exceeded 5 percent

National Savings Rate of India (1950-2009)30

.040

.050

.0G

ross

nat

iona

l sav

ings

as

% o

f GD

P

9

10.0

20.0

30.0

Gro

ss n

atio

nal s

avin

gs a

s %

of G

DP

1950 1960 1970 1980 1990 2000 2010Year

GDP growth above 5% - Not that unusual8

1012

10

46

02

1950 1960 1970 1980Year

Note: Bars are shown for the years between 1950 and 1979 when GDP growth was above 5 percent.

Real GDP growth 1950-2009

8.0

10.0

y5gd

pk

11

2.0

4.0

6.0

y5gd

pk

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010Year

Puzzle 2: How come India had big reforms and no growth acceleration?

� There wasa significant 2 percentage point acceleration for 3 years soon after the

reforms – growth averaged above 7 percent 1994/95 – 1996/97.

�The post-reform decade from 1992-2002 witnessed only a 5.5 percent average

growth rate, no different than the 11 years from 1980-1990.

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growth rate, no different than the 11 years from 1980-1990.

� Competing explanation: Indian potential growth rate had already reached its

potential of around 5.5 percent in the mid 1980s; so we shouldn’t expect much

acceleration in the 1990s.

Puzzle 3: What caused the growth rate to really accelerate from 2003/4 onwards to an average of 8.2 percent for the last seven years?

� Several explanations:

1. Rising tide lifts all boats

2. Indian industry so decimated by the tightening of the mid 1990s that

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they regrouped and became superior

3. Reforms of the early 1990s finally had an effect more than a decade

later

� Problems with each interpretation

1. No other country has had such a large expansion in investment rates

2. Post hoc, ergo propter hoc

3. Possible, but then India will have the record for the longest gradualism lag

So what really happened?

� Going back to the determinants• Currency undervaluation – consistent policy of maintaining a constant real exchange rate, which because of higher productivity growth in India, meant a slowly increasing currency undervaluation; so no extra effect• Middle class – this has long term impact and each 10 percent increase in the size of the (lagged) middle class adds about 0.4 percent to GDP growth rate –so this factor accounts for little• Cost of capital – yes– each 1 % decline in the lagged real interest rate adds

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• Cost of capital – yes– each 1 % decline in the lagged real interest rate adds about 0.35 percent to GDP growth

� Real interest rates declined because nominal rates declined; inflation stayed low at around 4 percent.� Small savings rates which were 12.5 percent in 1999 were brought down to 8 percent by 2003/4.� Real rates on government securities were 7.3 percent in 1999, and averaged 2.6 percent between 2002 and 2007; a decline of 500 basis points or close to 2 percent extra GDP growth.

Money Supply and Fiscal Deficits: (non)-Effects on Growth and Inflation

Coefficient 1950-72 1980-07 1950-07

Dependent variable: GDP Growth

M3 Growth (lagged) -0.03 -0.08 0.20**

Inflation -0.06 -0.20 -0.24**

R2 0.45 0.53 0.46

Dependent variable: Inflation (GDP deflator)

M3 Growth (lagged) -0.20 0.32 0.48**

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Notes: (1) *Stars indicate the level of statistical significance; 1, 2, and 3 stars indicate significance at the 10%, 5%, and 1% level of significance, respectively. (2) Other variables in the equation are rainfall, rainfall lagged and in growth equations, a dummy variable for 1991, when applicable.

GDP Growth 0.48 -0.64* -0.60**

R2 0.26 0.31

1980-03 1980-03 1980-07

Dependent variable: GDP growth

Fiscal Deficit lagged (% of GDP) -0.23 -0.38* -.24

Real Interest Rate (lagged) -0.25*** -.38***

Currency Undervaluation (lagged) -.01* -.024***

R2 0.71 0.79 0.76

Domestic and World Inflation

Dependent Variables: Inflation (GDP deflator)

1950-80 1980-07

Variables 1 2 1 2 3

World Inflation 0.32* 0.38** 0.68*** 0.35*** 0.28***

World

India

10.0

15.0

16

Undervaluation USA 0.12

-

0.07***

-

0.07***

Undervaluation India -0.05

0.013**

*

0.014**

*

R2 0.14 0.27 0.69 0.77 0.87

*Stars indicate the level of statistical significance; 1, 2, and 3 stars indicate significance at the 10%, 5%, and 1% level of significance, respectively. Note: Model 3, 1980-07 has a dummy variable for crisis year 1991.

0.0

5.0

1980 1985 1990 1995 2000 2005year

Relationship between interest rates and GDP growth

2004

2006

2003

1994

20052007

1998

1995

19961999

6.0

7.0

8.0

9.0 1995

2005

2004

2007

1994

1993

1999

2006

1996

200301

2e(

ygd

pk |

X )

17

Notes: The graph outlines the close partial relationship between real interest rates and growth; The X axis is the real interest rate on government securities and the Y axis GDP growth. Note that the model estimated includes other factors, including currency undervaluation. Hence, the relationship shown is a partial relationship i.e. one which exists after controlling for the impact of other determinants.

1993

20021997

2001

20004.0

5.0

6.0

0.0 2.0 4.0 6.0 8.0rrgsec

% change GDP Fitted values

20021998

1997

2001

2000

-3-2

-1e( y

gdpk

| X

)-4 -2 0 2 4

e( rrgsecl | X )coef = -.62016498, (robust) se = .08579753, t = -7.23

Notes: The X axis is the real interest rate on government securities and the Y axis GDP growth. This chart does not account for the presence of other determinants in the model

GDP growth and lagged real interest rate – Are they related?

-6-4

-20

ilkrg

sec

6.0

8.0

10.0

ygdp

k

Decade GDP Growth Real G Real P

1960s 3.9

1970s 2.8 5.6

1980s 5.5 1.6 8.3

1990s 5.5 4.0 7.2

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Correlation between GDP growth and lagged real government securities rate from 1993 – 2008 is 0.79.

-8-6

4.0

1990 1995 2000 2005 2010Year

ygdpk ilkrgsec

2000s 7.0 3.1 7.3

2010s 8.6 2.6 7.6

Real G= real government securities rate

Real P = real prime lending rate

Partial regression plot of (lagged) currency undervaluation and GDP growth, 1993-2007

2007

2006

2000

20012003

1999

1998

2004 1996

01

2e(

ygd

pk |

X )

19

2000

2005

1998

1997

19942002

1995

1993

-2-1

0e(

ygd

pk |

X )

-40 -20 0 20 40e( uvl | X )

coef = -.04039563, (robust) se = .01321022, t = -3.06

Partial regression plot of (lagged) real interest rates and GDP growth, 1993-2007

1995

2005

2004

2007

1994

1993

1999

2006

1996

200301

2e(

ygd

pk |

X )

20

1993

20021998

1997

2001

2000

-3-2

-1e( y

gdpk

| X )

-4 -2 0 2 4e( rrgsecl | X )

coef = -.62016498, (robust) se = .08579753, t = -7.23

Investment Rates – A comparison

China 1980Japan 1960

35.0

40.0

45.0

Pattern of Investment Rates

21

Note: Each countries investment rate in the 0th year is the year indicated next to that country’s line e.g. 1990 for India, 1975 for Korea. The X axis measures the number of years elapsed since the start date. Note that for the last seven years,

India’s increase is the steepest.

India 1990

Malaysia 1970

Korea 1975

20.0

25.0

30.0

0 5 10 15 20Number of years

Potential GDP Growth in India >= 8.5 percent

Long term Average = 6.4

Potential Growth

810

22

Long term Average = 6.4

Average 5 year growth

24

6

1980 1990 2000 2010Year