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Tuesday, March 28, 2006

How did the 7 percentage point swing in investment/GDP ratio happen?

One of the most remarkable things about the recent Indian macroeconomic experience has been the rise in the investment rate from 23% in 2001-02 to 30% in 2004-05. This is a huge seven percentage points of GDP of a rise over a mere 3 year period.

Ila Patnaik has an article in FE about how this happened. The pieces appear to be:

  • Net capital inflow into the country swung from -0.7% (a current account surplus) to +0.8% (a current account deficit) - a gain of 1.5 percentage points.
  • The biggie was the consolidated public sector, which swung from -2% to +2.2% - a gain of 4.2 percentage points.
  • Retained profits of the corporate sector went up from 3.6% to 4.8% - a gain of 1.2%.

These three pieces add up to a swing of 6.9% of GDP, and are the bulk of what happened.

As Ila emphasises, these changes are about the tactical evolution of economic policy coupled with the business cycle. They are not about the `demographic dividend', as has been claimed by many people.

A business cycle downturn will affect both the public sector (lower tax revenues, lower PSU profits) and the private sector (lower earnings). So a simple business cycle downturn could lead to a peeling of a lot of these gains. The UPA's exuberant spending programs could generate a deterioration of the public sector numbers.

The 1.5 percentage point swing in the current account surplus was primarily a gift caused by higher oil prices. The currency regime also did improve slightly, but that played second fiddle. RBI basically kept hanging on to the pegged exchange rate regime. It just so happened that an oil shock came along and at the old rate (which RBI was hanging on to) we flipped to a current account deficit. We haven't yet got a currency regime which can deliver a sustained current account deficit.

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