India's trend GDP growth rate : 9% or 7%?

A short while ago, I wrote a BS article and blog posting about the remarkable GDP growth numbers that have been coming out. This was discussed on the Indian Economy Blog at the time and then again recently. The subject is particularly topical because of today's data release showing a fantastic 9.2% GDP growth (WOW!).

What is at stake is the distinction between trend and cycle. All market economies experience a business cycle. Even though Chinese data shows virtually no business cycle fluctuations to speak of, I'm pretty sure that a globalised market economy like China experiences a business cycle; it's just not being captured in the data properly.

How do you define trend and how do you define cycle? There are many ways of separating trend from cycle. I like a simple heuristic: I call the average growth over the latest 10 years to be the "trend growth rate". Ten years is a long enough period that it averages over ups and downs. The deviation from this trend is what I call "cycle". There are other ways, and in my judgment the answers don't differ by too much.

Going by this definition of trend, we find that from 1979 till 2006, trend GDP growth ticked up slowly from 3.5% to a shade below 7%. This is a very impressive achievement. But it highlights one important fact. All the wonderful things at work from 1979 to 2006 generated an improvement of 3.5 percentage points over an aeon (27 years). And there were a host of wonderful things at work in this period. The savings rate went up. The size of the workforce rose nicely (the so called `demographic dividend'). Many improvements in the economic policy framework took place - I think it's fair to say that the policy environment is completely transformed between 1979 and 2006. All these wonderful changes added up to a gain in the trend rate of 3.5 percentage points over a 27 year period.

I am optimistic about further improvements in the savings rate. I am optimistic about further improvements in the quantity and quality of labour. I am cautiously optimistic about the possibility that the economic policy might actually get a bit better. I expect the trend GDP growth in India will accelerate beyond 7%. (See these materials if you are curious about the past and future acceleration of trend GDP growth). But even the most adventurous optimism in these regards does not support an expectation of a sudden escalation of trend growth. These things only change slowly. GDP is a massive enterprise pumping out Rs.30 trillion per year. That is a lot of money; it is a vast enterprise of a great deal of producers. It does not change quickly. If we add 100 to 200 basis points to trend growth over a decade, I would say it's a grand achievement.

Further, I do not treat a further escalation of trend GDP growth as inevitable destiny. The world economy could have a nasty downturn. Indian economics and politics could go awfully wrong. Many countries have done very well in short spells and then run afoul of problems and thus faced growth decelerations. Think about it - what if the UPA does something on reservation which ignites blood in the streets like the Mandal Commission period? We in India have lived in a great period, where trend growth has accelerated for 27 years, and it's been a great ride. But we should not expect a further acceleration of trend growth as inevitable destiny.

Some ask whether it's fair to talk about trend growth at 7% when the latest quarter has shown 9.2%. Is an estimate of trend growth of 7% sensible, when we've got one quarter growth of a full 2.2 percentage points above it? My response lies in `procyclical policies' that India is following. The way India works, capital flows do well when things are good, RBI cuts real interest rates when capital flows come in, the government spends more when things are good. All this acts as a stimulant and exaggerates the good times. I say this with great sadness because all these aspects will exaggerate the bad times when they inevitably come. India has a poor macro policy framework. What Indian macro policy does is to magnify the cycle, to exaggerate the fluctuations. This is part of why we see a one-quarter result of 9.2% at a time when the trend is more likely to be ~ 7%.

Some say that I shouldn't worry about the gloomy outlook for world GDP growth when India and China are doing so well - these countries can power the world economy. The data doesn't support that. China is 5% of the world's GDP and India is 2%. The numbers just aren't big enough to counteract sluggishness in the US, Japan and Eurozone, all three of which are likely to turn in anemic numbers in the next 12 quarters.

Update (2006-12-13): Akash Prakash has a main piece in Business Standard today on these issues.