Revisiting India's growth

Policymakers are concerned about smoothening the impact of the ups and downs (called business cycles) by understanding how close the current output is to the economy's long-term potential output. Output gaps are no crystal balls, but they can reveal a lot about the future course of various macroeconomic variables. Output gap may be positive or negative. It is positive when actual output exceeds the potential, and this reflects that factories are operating above capacity and hire more workers to meet the demand, and is the harbinger of mounting price pressures. A negative output gap is indicative of slack in the economy due to weaker demand and gaps in capacity utilisation. Given this, it would not be difficult to appreciate that the output gap is an instantaneous indicator of the relative demand and supply components of economic activity. There are several techniques to estimate the potential growth; this article relies on a simple statistical method which identifies potential through the deviation of the actual output from its trend, and minimises it while adjusting for the sensitivity of the trend to short-term fluctuations.

The comparison of growth with its potential is shown in the adjoining figure. The figure suggests that the potential GDP growth of India since the early 1990s has consistently demonstrated an upward trend, peaking in 2006 to 2009. It briefly treads down following the global financial crisis of 2008, but has unswervingly remained close to 7 per cent. With GDP growth performing below the potential at the advent of the 1990s, the onset of the reforms leads to a sharp positive output gap as the economy expanded on the back of liberalisation and improved international linkages. Except for one brief descent, India's growth continued to outperform its potential in the 1990s, only to be interrupted by the impact of the East Asian Crisis which dried up capital flows to the emerging economies towards the turn of the century. Starting 2003, global recovery began and world trade picked up, which had been dormant since the crisis, leading to growth in India's export earnings. Loose monetary policy exercised by the US and Japan allowed investors to take advantage of the interest rate arbitrage and direct liquidity to emerging economies. Being at the receiving end of this global liquidity surge from 2003 to 2008, the output gap turned sharply positive in India as the GDP grew at the rate 9 per cent per annum in this period, second only to China's growth rate. This streak of 'India's dream run' faltered, albeit marginally, at the outbreak of the Global Financial Crisis of 2008. Initially, India seemed to be insulated from the crisis, as growth exceeded its potential again after a temporary fall and remained high thereafter. This 'decoupling' was on account of factors such as limited capital account convertibility, nearly no sub-prime assets and linkages to the failed institutions, among others. But, as the global economy continued to grapple with recessionary pressures, the output gap became negative in India as well in the period between 2011 and 2014. The output gap turned positive since 2014 as India registered close to 8 per cent rate of growth and foreign inflows poured in due to the sound macroeconomic fundamentals and a renewed faith in the Indian story. But, the oscillation resumed as GDP growth fell below potential after 2016 and has remained so up to December 2017 (latest available data).

This analysis of output gaps over the last 25 years reveals two keys insights. One, due to an increasingly globalised economy, the domestic output gap is very sensitive to the international policy space. This is reflected through the emergence of a negative output gap in response to the East Asian Crisis and the Global Financial Crisis, owing partly to the reliance on foreign inflows as well the pro-cyclical nature of Indian exports. It is also evident through output exceeding the potential after the globalisation of the economy in the early 1990s and loose monetary policy abroad after 2002. Two, the recent negative output gap is narrower than ever since the last two and a half decades. The recent past saw disruptions in GDP growth following the twin policy shocks of demonetisation and the introduction of the Goods and Services Tax. Growth did falter, but as structural adjustments gather pace, the indirect tax reform will go a long way in enhancing the long-term potential and closing the output gap. These policies are aiding formalisation of the economy and the benefits are already evident through improvements in tax collection.

The current international macroeconomic landscape is favourable for domestic growth as synchronised global recovery continues in earnest and India is well equipped to deal with monetary policy normalisation. With commodity prices and inflationary pressures in check, the speedy resolution of stressed loans along with recapitalisation and cleaning of bank balance sheets and the domestic macroeconomic milieu is also considerably conducive to higher growth accelerating further. The government is doing well to monetise the output gap through considerable infrastructure and social sector expenditure to boost output and employment. Lower than expected borrowings by the government in the first-half of the fiscal year leading to softening of bond yields, complemented with status quo by the RBI on the repo rate will ensure low borrowing costs and spur investment. In Toto, these observations hint that the output gap is poised to close as the Indian economy heads closer towards its potential growth.