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Wednesday, 23 April 2014

India 2005 - Consider India

More than 40 years ago, the OECD asked the world to “Consider Japan”. Huw McKay, senior international economist at Westpac Economic Research, poses a similar challenge here with respect to the future place in the world of the Indian sub-continent.

Japan more than doubled its share of global output between 1954 and 1974. China performed a similar trick, from a higher base, between 1981 and 2001. Our projections indicate that India will rapidly increase its share of world production from below 6% in 2000 to above 9% in 2020. That suggests to us that India can no longer be ignored in the formation of long-run views on the global economy.

Central to the argument is a growth accounting exercise that projects a future potential growth rate for India in excess of 7%.

So, how did we arrive at our estimate of India’s future growth potential? First, we assembled data on Indian economic performance over the past two decades. Second, we projected growth rates in the labour force, capital stock, total factor productivity and labour force quality. We then entered these assumptions into a standard growth accounting framework.

On the growth of the labour force, we expect the demographic profile to be supportive of growth through the projection period. Indeed, India will have a strongly growing labour force well past the end-point of our little experiment. On our figuring, the labour force can grow at an average rate of 1.9% through 2020. Weighting that by the labour share of income gives a potential growth contribution of 1.24 percentage points through the forecast period.

We also need to make an adjustment for labour quality. We note that the quality of labour made an average contribution to Indian output growth of 0.38 percentage points through the last two decades. With primary education levels in Indian lagging those in comparable economies (China, for instance), and the rise of smart industries increasing the domestic return to education, we expect some catch-up in this area. We have conservatively assumed that the contribution of labour quality to potential growth will accelerate to 0.5 percentage points.

That leaves the contribution of labour at around 1.75 percentage points.

Moving on to the capital stock, we believe that given India’s relative state of backwardness, returns to capital will remain high through the projection period. Also, given India’s relatively low investment share relative to other major developing Asian economies, we can reasonably expect the capital stock to grow faster than overall activity as India plays catch-up in this area also. Indian infrastructure clearly lags that of major comparison countries. Furthermore, a forecast decline in the dependency ratio will flow through to a significantly higher savings rate, implying that an upward shift in the investment share can be met without hitting an external financing constraint. In sum, the weight of arguments point towards an acceleration in the rate of growth of the capital stock through the projection period.

Once again, we arrive at a relatively conservative contribution. Assuming that the capital stock expands by 8% per annum through 2020, its contribution to potential growth for the period will by 2.8 percentage points. That compares to a 1.2 percentage point contribution to growth over the previous two decades.

That brings the potential contribution of “input-driven” growth to 4.54 percentage points, or roughly equal to actual growth for the 20 years prior.

To that we must now add an assumption on total factor productivity (TFP) growth. History shows that India has been able to sustain a TFP growth rate of 2.5%, despite not fully embracing the twin themes of globalisation and discipline through competition. Further opening up to trade, bureaucratic reform, an increase in the capital/output ratio and privatisation all have the potential to drive TFP higher.

Other factors could also be mentioned, such as ICT diffusion, infrastructure development, FDI and technology transfer, all of which point towards a stronger TFP performance in the future than in the past. Our assumption incorporates a conservative acceleration in TFP growth to 2.75% through the projection period.

That brings the potential future growth rate of the Indian economy to 7.3%, under admittedly conservative restrictions.

If India achieves growth of this magnitude, we will see a significant shift in the sources of global output. India and China will both grow much faster than the rest of the world between now and 2020. The rise of these two regions will result in a marked increase in the share of output emanating from emerging Asia. The other side of that coin is that the more mature regions, where growth will be more subdued, will see their shares of production decline.

This trend has major implications for the composition and pace of global growth. The compositional effect is perhaps the most interesting. As less developed regions such as India and China comprise a greater and greater share of output, the composition of this output becomes more important for the balance of global sectoral demands.

Put more directly, poorer regions do not have highly developed services sectors. Services on the other hand dominate output in the developed world. Therefore, as global growth becomes to depend more heavily on emerging markets, the share of services in global production will decline. That is because emerging markets devote a great deal of their resources to building up the capital stock from a low base. That increases the investment share at the expense of consumption, as domestic savings rise to meet higher investment demands. Furthermore, poorer countries devote a relatively smaller share of their consumption to services, and a relatively larger proportion to staple goods such as food and housing. Together this all implies a shift in demand towards goods and away from services, where the developed world has a clear comparative advantage.

A stronger hand for developing regions is an extremely positive scenario for the suppliers of raw materials and simply transformed resources. With economic growth comes increased per capita consumption of energy and metals. With industrialisation comes urbanisation. With growth comes higher incomes, a growing middle class, poverty reduction and a more resource intensive lifestyle. These trends all apply to India. When the per capita calculation involves a population approaching 1.1bn, the extra volume of resource demand we can project is enormous.

Consider the urbanisation angle. The UN projects that India’s urbanisation rate will rise from its current 28.3% to 34.7% in 2020, and 41.4% in 2030. That implies that India could increase steel consumption per head by more than five times from its current very low level by 2030. With China also sharply increasing its consumption per capita (from a higher base) over the same time frame, the long-run prospects for the resources industry are worth salivating over.

The trends in electricity consumption per head are just as strong. Indeed, the slope of the fitted curve in GDP/capita and electricity use/capita space is much steeper at lower levels of income than is the steel/urbanisation curve. That implies even larger volume gains for energy producers relative to metal suppliers whilst India remains below the US$10k per head level of income.

India’s current energy supply is heavily concentrated on its own extensive coal reserves. India relies on crude oil imports for around 12% of its total energy needs, compared to 9% in China, 22% in Indonesia and 28% for the United States. So while India is currently relatively insensitive to shifts in global oil market trends, as the economy’s appetite grows, it will find as others have done that energy self-sufficiency is a luxury afforded to few. And as the economy wrestles with the environmental consequences of a coal-based generation grid, it is not hard to project a much greater reliance on the import of non-coal fuels.

The rise of India, in tandem with the well-established growth trends in China and emerging Asia, will help sustain a structural move in the demand/supply mix in favour of resource suppliers over resource consumers.

A further issue that should be addressed is India’s current and future level of competitiveness. Despite its large local market and low wages, India has not been a popular destination for foreign direct investment (FDI) in the manufacturing sphere. Studies have shown that Indian competitiveness lags China’s appreciably, with infrastructure provision, excessive red tape, indirect taxes, and soft domestic competition as commonly cited disadvantages. In 2003 India attracted less than 1% of GDP in FDI, against almost 3% for China. India needs to reform its bureaucracy and tax structure, and engage more strongly in international trade if it is to close the competitive gap.

The advantages that India does have are its long-run demographic profile, and the quality of portions of its labour force. We have already noted that India’s labour force growth will remain quite rapid through the next few decades. China will not have this advantage, with the one-child policy of the late 1970s putting China on an aging trajectory not far removed from that of the developed world. That implies that from a demographic perspective, India will eventually be in a position to supplant China from its dominant position at the low-value added end of the manufacturing chain. An apposite run of reforms neutering current non-labour related disadvantages should make this transition a formality.

India must engage more closely with the rest of the world in trade. India’s exports per capita ratio is deficient, even when compared to other populous emerging markets. Japan has shown that coddled domestic industries can seriously prejudice the overall rate of growth. India must open up whilst growth is still “cheap”, to prepare for the times when labour force growth slows and the capital stock begins to attract diminishing marginal returns. At this point productivity will supply the lion’s share of output potential.

This article has done three things.

First, it has offered a decomposition and projection of India’s potential growth rate, concluding that India can grow faster than 7% per annum through 2020.

Second, this growth profile was inserted alongside our projections for regional and world growth out to 2020. This experiment shows that India will become an increasingly significant element in the growth of global output.

Third, the above findings were then applied to a variety of issues of import to the markets and policy makers. These included the evolving composition of global output, demand for commodities and energy, and shifting competitiveness in the manufacturing sector.

The cumulative sum of the arguments and scenarios presented point in a single direction. India is on the cusp. Governments, corporates and markets would do well to begin considering India.

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