11 Feb 2021
02 Feb 2021| Piya Sachdeva, Economist
Piya Sachdeva explains why expectations for long term growth look over optimistic, and assesses how the country might lift potential growth.
Investors generally see India as one of the few major emerging markets that will be able to deliver rapid economic growth for the forseeable future. But are expectations for long term growth too optimistic? We find that India's potential growth lies around 6%; this is about 1% lower than other estimates from international bodies like the International Monetary Fund (IMF).
Valuation measures attached to Indian equities suggest that expectations are high for the Indian economy. The potential growth rate of 6% means that, going forward, India will struggle to achieve the persistent double-digit growth it experienced in the mid-2000s. This is because in periods of rapid, above potential, growth, it will be quickly capped by rising inflation and widening external deficits. This year should be an exception due to the amount of spare capacity in the economy.
On the plus side, India could raise its potential growth rate significantly. To do this, it would have to boost investment to raise capital per worker, raise participation in the labour force and focus on other reforms that raise productivity.
The potential growth rate of an economy is the pace at which a country can expand without generating inflation and captures the supply-side of the economy. It is an important concept for investors as it helps determine the balance of supply and demand in the economy, or the output gap. This impacts inflation and in turn, interest rates and competitiveness. Potential growth is also the anchor for long run growth assumptions, so is also a key part of debt sustainability.
Over the last two decades, growth has slowed significantly after averaging almost 10% in the mid 2000s. Growth fell to 7% in the mid 2010s and to 4% year-on-year (y/y) the quarter before the Covid-19 crisis.
We use Gross Value Added (GVA) data from the Reserve Bank of India (RBI) to break down economic growth into its two supply components; workers (labour) and the amount of output each worker produces (labour productivity). Though the accuracy of data is questionable, it still does a good job of telling the story.
We look at the change in GVA in the periods we highlighted to see what caused the acceleration and slowdown in growth. As shown below, the rise in growth in the mid-2000s was caused by an improvement in labour productivity growth, which rose from 3% y/y to 7% y/y.
But while labour productivity has continued to grow around this rate during the last decade, there has been a slowdown in the contribution of labour. This is likely surprising to investors who will no doubt be familiar with India’s favourable demographics, often dubbed its “demographic dividend”.
There are a few reasons for this. Firstly, growth in the working age population has slowed from around 2.1% per year in the mid 2000s to around 1.3% today. But more importantly, in the last decade or so working age population growth has outstripped jobs growth. Participation in the labour force has also been falling. This is worrying, particularly for females, where participation is only one in five and already very low compared to India’s peers. Attempts to explain the fall in female participation have so far been centered around the lack of demand for moderately educated women, the effect of household income on female participation and the measurement of formal sector participation.
At this point, we should warn readers that there is scarce labour market data in India. It only covers the formal sector which is just 10% of the total labour force, according to the International Labour Organisation. But the data we do have suggests strong growth in India has not been accompanied by enough formal job gains. This is a crucial point. To reap its demographic dividend, India must create enough jobs for the people entering the workforce.
In order to form a view on labour productivity, we must dig a bit deeper into its three drivers. The first driver of productivity is education which can be viewed as the quality of labour. The second driver is how much capital each worker has, known as capital deepening. In our calculations of capital deepening, we also include how well the existing stock of capital is used. The third driver is how well capital and labour are combined to form output. This is known as total factor productivity (TFP). Given that TFP is unobservable, it is often the residual in calculations and can be thought of as the growth in output that improvements in capital and labour cannot explain.
When we look at the drivers of labour productivity in India, what stands out is that the rise in the amount of capital per worker through the mid-2000s peaked in 2007 and never returned to these levels of growth. This is consistent with the fall in investment growth that India has experienced since 2010. In the meantime, TFP growth has not helped boost productivity growth in a sustainable way and labour quality has been fairly stable.
The outlook for potential growth depends on labour and labour productivity.
Labour supply
Without immigration, the outlook for the supply of labour in an economy is underpinned by demographics. In India, working age population is expected to grow by an average of 1.2% per year for the next five years. Crucially, the contribution to growth relies on India creating enough jobs for incoming workers. For the next five years, India will need to create roughly one million jobs per month to do this.
If India is also able to raise participation in the labour force, labour could add even more to potential growth. This is going to be very difficult and would take years to be lifted meaningfully. For now, we assume that participation stays constant.
Labour productivity
Though it could be improved considerably, labour quality growth has historically been quite stable. TFP growth has no trend and has been volatile, making it extremely difficult to predict. It seems prudent to assume that labour quality and TFP will stay at long run average growth rates. This is 0.3% y/y and 3.6% y/y, respectively.
This leaves the capital and investment outlook. Investment fell sharply last year and is set to rebound this year as part of the wider cyclical recovery. But credit growth remains subdued, hindered by poor asset quality in the banking sector. This leaves little hope of a structural investment boom. We assume that capital per worker growth returns to its long run average, which is just below 2019 levels of growth. Historically, this has been consistent with annual investment growth of around 8%.
Putting this together, we assume labour growth of 1.2% per year and labour productivity growth of 4.8% per year. This points to our estimate of potential growth being around 6% for the next five years. This is lower than other estimates from international bodies like the IMF who pencil in 7.3%. Though the IMF do not provide a breakdown of their assumptions, this is most likely due to our more pessimistic central outlook on labour productivity growth.
India can raise its potential growth in various ways. It could raise participation in labour force, particularly for females, and levels of labour quality by investing in education. India needs to shift employment from labour-intensive and therefore less productive areas of the economy, such as agriculture, into less labour-intensive, higher productivity parts of the economy, such as manufacturing and even construction. Measures to clean up the banking sector would also help boost credit growth for the required investment. Finally, policymakers should reignite various other elements of structural reform, including land and labour, which could raise productivity across both services and agriculture. Investors considering India should watch out for any progress in these areas.
The most recent steps by the government have been to pass three reform bills that allow farmers to sell their products directly to buyers; bypassing licensed traders in local markets. This should enhance competition and boost agricultural incomes. However, as a result of a backlash from farmers who fear the end of price floors, the bills may now be watered down, deferred or even abandoned. This would be an unwelcome development for investors and could be the price paid by Prime Minister Modi for pushing through bills without broader debate.
Stepping back, the potential growth rate of 6% means that, going forward, India will struggle to achieve the persistent double-digit growth it experienced in the mid-2000s. This is because in periods of rapid, above potential, growth, it will be quickly capped by rising inflation and widening external deficits.
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