Real challenges for the Finance Minister

The recent cover story in The Economist about the Indian economy being overheated has excited a great deal of debate. The recent trend in inflation, which is now well above the 5 per cent tolerance threshold, has reinforced these fears. Should the FM and RBI press on the brakes? And if they do what happens to the 11th Plan's 9 per cent growth target?

The Economist sees a sign of pressure in the widening current account deficit. But that is something that we have been aiming at for some time. After all there is no point in accumulating even more reserves.

A further factor that they draw attention to is that the deficit is larger if we leave out remittances, presumably on the grounds that they are akin to capital flows. But are they? Remittances are not NRI deposits. They do not generate any repayment liability. They may well be saved by the recipients, but that does not alter the income character of the flow. Nor is there any reason for supposing that they are suddenly going to dry up. In fact they are one of the most predictable and stable items in the balance of payments.

The Economist also questions the productivity gains implied by the recent growth figures, particularly for the services. It argues that services output growth may be overestimated and this may have led to high estimates of productivity growth. But if services growth has been overestimated, then the overall GDP growth would also be overestimated. Hence the argument that the current growth rate is much higher than the growth in supply potential would also need to be corrected.

Basically The Economist does not believe that the Indian economy is on a sustainable 9 per cent growth path. Presumably it attributes the high growth record since 2003-04 to better capacity utilisation. It does not believe that long-term productivity growth has accelerated and it is sceptical about the demographic dividend because much of the growth in working population will take place in the stagnating states of the northern heartland.

The Economist fears about over-heating may be exaggerated. The only real evidence is the increase in the rate of inflation, mainly on account of food prices. But a 6 per cent inflation rate is not any reason for panic stations in North Block or the RBI. India's interest rates are already quite high by international standards and the last thing one wants at this point is for the RBI to choke off the high rates of corporate investment, which will add to capacity, which in turn can help to contain inflationary pressures and maintain the high growth rates achieved since 2003-04.

A more likely source of problems is the possible reversal of FII inflow. It is believed that some of this inflow depends on low-cost borrowings in Japan being used to acquire quick-return assets the world over. But this is a sign of under-heating in Japan, not over-heating in India.

Our foreign exchange reserves will allow us to ride the balance of payments impact. But the potential impact on the stock market, and through that on corporate investment is another thing. The FM would do well to keep a stock market sop up his sleeve, to be trotted out if this eventuality arises.

Leave over-heating to one side. Are The Economist's doubts about the underlying growth trends correct? Are we set on a 7 per cent rather than a 9 per cent path, projected in the 11th Plan?

Usually the feasibility of projected growth rates is looked at in terms of the plausibility of the assumptions made regarding the rate of investment and capital productivity, say, as measured by the incremental capital-output ratio. For what it is worth, the implicit ICOR for the 11th Plan is 3.9.

This may be an optimistic assumption, given the greater weighting of manufacturing in output growth and the priority for infrastructure investments in capital-intensive sectors like power. In terms of total factor productivity the implicit assumption may be about 3.5 per cent annual growth, which is higher than the realised rates in the past two decades.

Three crucial developments will determine whether these projections of investment and productivity will be realised-agricultural growth, government savings and the productive use of capital inflow. On the first two counts the 11th Plan projections involve a significant break with the recent past.

The real challenge for the FM is to come up with credible measures that can boost agricultural growth (but not some ill-considered subsidy scheme, please!), and continuing the improving trend in the revenue deficit. A better than expected performance on the deficit will calm the fears of overheating.

But that is not enough to make the Plan projections credible. Judging from experience, the key to sustaining high growth lies in a continuous effort at maintaining global competitiveness, ensuring a steady shift in production functions that could be described as "technological dynamism" and institutional developments that allow markets to function efficiently.

An outward-oriented development strategy generates pressures for technological dynamism in both senses-improvements in efficiency in established products and processes and the introduction of new activities, new products and new processes.

But more needs to be done to boost technological dynamism. This goes beyond factor productivity growth. It involves the rate at which innovations in the form of new products, processes, and business practices are introduced and the rate at which new markets are penetrated. This Schumpeterian dimension is perhaps the most important in the long run.

Technological dynamism requires engineering skills and innovation needs investment in R&D. India started early on this track and some of the growth that we see today is a product of that foresight. However, it runs the risk of being left behind by countries like China. This is one area where no country leaves everything to the market. Public support for education, research and innovation is essential.

The other factor is competition policies that allow all markets, including the market for corporate control, to operate transparently. Here too we need more work on the credibility and efficiency of our regulatory bodies and their independence from random political interference. More than that, making markets work also involves modernisation of trading practices for instance for commodities.

Our ability to address these long-term problems rather than short-term imbalances will determine whether the present high growth rate can be sustained.