‘Rich-poor divide could kill the growth goose’

As P. Chidambaram presents the UPA goverment’s fourth budget, MARK BRADSHAW forwards a copy of the Goldman Sachs Report on India for 2007. After savouring the “fantastic optimism”, you are well tempted to ask, “What are they smoking?”

On the other hand…

***

India’s growth since 2003 represents a structural increase rather than simply a cyclical upturn. India ‘s potential or sustainable growth rate is projected at an average of 8.4% until 2020. This is significantly higher than the 5.7% that was projected in the original BRICs paper of 2003.

The implication of this is that India will overtake the G6 economies faster than envisaged in the earlier BRICs research. Indeed, India ‘s GDP (in US $ terms) will surpass that of the US before 2050 to make it the second largest economy. India ‘s contribution to world growth will aslo be increasing.

In India , labour is nearly 4 times more productive in industry and 6 times more productive in services than in agriculture, where there is a surplus of labor. Economic theory tells us that as labour moves from low-productivity sectors such as agriculture to high productivity sectors such as industry or services, overall output must improve.

Given that the movement from agriculture to other sectors (which in India’s case is roughly equivalent to the move from rural to urban areas) is still in its initial phase, the expectation is that the gains will continue to increase for several decades. Indeed, agriculture still employs close to 60 % of the labor force with negative marginal productivity.

After the onset of reforms in 1991, India began to unshackle its closed economy. Average tariffs have fallen to below 15% from as high as 200% as India began to reintegrate with the world economy. The impact of the opening up has been significant. Exports have risen 14 times as India has gained trade share. This development has been most evident in the past three years, when trade has grown 25% a year.

Increased openness has contributed significantly to increasing productivity. It provided access to superior inputs, ideas, and technology to domestic firms. Increased competition from actual and perceived imports has focused domestic firms on the need to improve efficiency as critical to survival.

It has rewarded the most efficient firms by way of access to foreign markets and larger gains, while penalizing the most inefficient domestic firms, thereby improving average productivity. It also encouraged a shift in employment from the less productive agricultural sector to more productive sectors.

India is well positioned to reap the benefits of favorable demographics, including an “urbanization bonus”, and a further rise in capital accumulation, in part from an upsurge in foreign direct investment.

Investment in highways is expected to reduce travel times by half, lower fuel costs and freight delivery times, and enable firms to leverage economies of scale, help ease congestion in cities, and attract activity.

Most importantly, the highways will open up, and out, the closed worlds of India ‘s villages. They will facilitate increased rural-urban migration, and when migrants return to their villages, they will bring back new views and aspirations, encouraging others to follow in their footsteps. The potential for productivity gains and boost to the economy are substantial.

India’s potential growth rates could increase further, given sustained productivity growth and favorable demographics, if it can significantly increase capital accumulation.

India would need to boost its investment rate by another 16% of GDP to achieve and sustain a growth rate of 10%. Thus, India would have to boost its savings rate by roughly 16% of GDP, through a combination of domestic and foreign savings, in order to finance the investment required for a sustained 10% growth.

The 21st century is set to become India ‘s ‘urban century’ with more people living in cities and towns than in the countryside. India has 10 of the 30 fastest- growing cities in the world and is witnessing rapid urbanization. The growth is happening not in the large cities, but in small and mid-sized towns. In 1991, India had 23 cities with a million or more people. A decade later, it had 35.

The projections show that another 140 million rural dwellers will move to urban areas by 2020, while a massive 700 million people will urbanize by 2050. This is because India ‘s urbanization rate of 29% is still very low compared with 81% for South Korea, 67% for Malaysia , and 43% for China.

The implications of urbanization for productivity growth are significant. Movement of labour across sectors, primarily from agriculture to manufacturing and services, adds 0.9% to GDP growth a year. Demand for urban housing and infrastructure such as electricity, health care, sanitation, and education is set to jump several folds.

Policy will, however, need to address basic infrastructure shortfalls in order to take advantage of the ‘urbanization bonus’.

To check the plausibility of the projections, it’s best to compare India ‘s growth projections with actual outcomes for its East Asian neighbors. Such high-growth phases during transition from low-income to middle-income are fairly common.

For instance, Japan increased its output eightfold between 1955 and 1985, while Korea increased its GDP by nearly 9 times between 1970 and 2000. More recently, China (starting from the same level as India in 1978) has achieved a more than tenfold increase in its output in the 27 years to 2005. By contrast, India ‘s growth transition, based on the projection of 8.4% growth from 2007 to 2020, do not appear implausible.

The risks to growth are: political risk, a rise in protectionism; supply-side constraints, including business climate, education, and labor market reforms; and environmental degradation.

A rapidly growing economy is often accompanied by an initial increase in income inequality (the famous Kuznetz curve), which in India ‘s case can manifest itself in a growing rural-versus-urban and an educated-versus-uneducated divide.

With rising aspirations, it is critical for the economy to have ‘inclusive’ growth, with employment opportunities for all. Education and labor market reform will be important. Otherwise, rapid growth could lead to rising social tensions, political pressure to slow down the reform process and increasing protectionism from reservations in education and jobs. If managed badly, this has the potential to kill the growth goose.

The old risk of sectarian disharmony is now supplemented with the new risk of political discontent spawned by dissatisfaction with the unequal distribution of economic growth. How effectively the political process manages these risks will be central to India ‘s economic performance.

Fortunately, thus far, there is wide consensus among political parties in India to enhance the reform process. However, there are considerable risks that India will not be able to achieve ‘inclusive growth’ without sacrificing average growth rates. The most direct manifestation of this risk is costs to the public sector of ‘populist’ policies which reduce public savings and the ability to finance the required investment growth.

In absolute terms India will remain a low-income country for several decades, with per capita income well below its other BRIC peers. But if it can fulfill its growth potential, it can become a motor for the world economy, and a key contributor to generating spending growth.

There are implications for India ‘s neighbors in South Asia, who also stand to benefit from spillovers, just as China ‘s growth aided its East and South East Asian neighbors. India’s influence on the world economy will be bigger and quicker than implied in previously published BRICs research.

The projections of India ‘s potential growth are based on growth-friendly policies continuing. In particular, policies to enhance financial sector growth, openness to trade, rural-urban migration, capital formation, education, and environment. These are “FORCE” factors critical to sustaining growth.