Can we grow at 5.6%?
This, to my mind, is the million dollar, oops, sorry, the 2 trillion dollar question. A lot hangs off this, doesn’t it? I mean, if we grow right and strong, a lot of things set themselves into correction mode. If the growth rate of the Indian economy moves from the current 4.6% to a 5.6% (an increase of 100 bps), then we have a chance to increase employment and consumption, better the standard of living and take a true shot at reducing poverty further. It also means that the FM will be able to collect more tax revenues; the Government will hence leave the household savings alone so that the private sector can avail of them. As the liquidity flow towards the private sector betters, higher growth will become possible.
How can we increase growth? Well, one great way of doing it is to increase investments. Does India invest enough? Compared to other developing economies, we have a pretty good investment to GDP ratio that stands at about 33%. And we have an excellent domestic savings rate to boot, with the savings/ GDP ratio standing at around 30%. So the domestic savings of 30% and the current account deficit of around 3% afford us an investment rate of 33% of GDP. Now, if the investment/GDP ratio is 33% and the Incremental Capital Output Ratio (ICOR) is around 4, then the Harrod Domar model of growth suggests that the growth rate of the Indian economy could potentially be 33/4 i.e. approximately 8.25%. And we are delivering a growth rate that is half of this potential outcome. This also means that the actual investment is far lesser than what the savings imply it to be. Where are we lacking?
Identifying the growth lacunae:
The first part of this story is that the entire household savings, which are at 30% of GDP, are not effectively available to anyone for investments. Why? The one year FD rates in India for the past 4 years have been below the inflation rate faced by Indian households; that makes it extremely attractive for the households to channelize their savings into non-financial or physical products like gold or real-estate. Such physical savings accounted for about 53% of the total savings in 2001; in FY 2013, the share has gone up to 68%. Till such a time that the FD rates show a healthy differential over and above the inflation rate, a large chunk of Indian savings will stay away from the private sector investors.
To channelize the household savings towards the financial sector requires the rates to increase, or the inflation to fall, or a much more stable and attractive financial intermediation process. None of these sound easy, right? Increase the deposit rates too much and the lending rates will increase accordingly; so the savings will be now ready for financial intermediation but no investment appetite will be left. So truly, the solution is not to tamper too much with interest rates, but rather focus on the inflation figures.
Why is the Indian inflation rate so very high? While demand increments have played a definite part, I think the more stronger and pertinent part is the supply shock. Now, to cure the supply shock, we are going to need big ticket, sustained and long term investments into critical infrastructure. For this, we need money. This implies that we have very less rope to give out subsidies. This Government not only has the political majority, but also the economic compulsion to deliver on the subsidies count. So, Modi Sarkar, please deliver on the subsidies. Communicate. Educate. Talk to the people about this. Coax them into it. Make them understand. Only a sustained reduction in the inflation rates will help the households to get their savings back into the deposits. And that will be a big boost to the investment capital that the country has.
The second part of the story obviously is the 3% current account deficit, which implies that there are foreign capital inflows to the tune of around 3% of GDP. However, these inflows, especially in the past 6 months, have been more of the portfolio types rather than the FDI and hence again, the actual investment rate suffers. Whether the increment in FDI limits from 26% to 49% in defense and insurance will actually give a boost to either sectors remains to be seen. Again here, the Modi Government needs to change the way the defence sector transactions are treated. To cajol investors into the country, the license requirements, monopsony of the Ministry of Defence, limits on defence exports etc. need to be liberalized.
Lastly, there is the issue of the ICOR being high in India, suggesting that there are governance issues due to which way too much capital is required to create some level of growth. Here, I think, is the key strength of the Modi Government. The Gujarat model was very successful in cutting down the bureaucracy, an act that needs to be repeated at the Center. A few moves are already looking good. The move to unify the power and coal ministry was simply wonderful. More such things are needed. Quick guidelines on PPP route of financing, urea reform, GST, DTC, PDS reform, crackdown on hoarders will help in streamlining procedures immensely. I don’t have data to prove any of this, but these are the moves that will change that stubborn ICOR to 3.
It’s unfortunate that data on ICOR is not available even at the national level very easily; the planning commission releases plan-wise ICOR data. But my feeling is that if the ICOR data were to be made available state-wise, Gujarat would show some of the lowest ICORs. And that is the secret to high investment and high growth trajectories. If the ICOR can be reduced, truly spectacular wale acche din aayenge!