India’s growth potential—lower but still tiger-like  Goldman Sachs,

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India’s growth potential—lower but still tiger-like
 Measuring India’s potential growth
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 is important for two reasons—how much has
medium-term growth been affected by the current investment slowdown and policy
bottlenecks, and how much is the current bout of inflation being influenced by a
positive output gap.
 According to our estimates, potential growth would decline modestly to 7.6% in FY13.
This is down from the pre-crisis level of 8%, primarily due to a slowdown in supplyside reforms and weaker investment. For every 1 percentage point fall in investment,
we estimate potential growth would fall by about 0.1 percentage point.
 The other drivers of potential growth—favorable demographics and productivity
growth, remain in place. Productivity growth had fallen during the crisis and has
shown some recovery since then.
 Disaggregated data shows that growth and productivity in the domestic-demanddriven services sector remains strong, thus suggesting downside support to growth.
 We provide some evidence to back the structural reasons for robustness in
consumption demand—a rise in agricultural wages, and a shift in labor from
agriculture to services where employee compensation is significantly higher.
 According to our forecasts, actual growth will likely be below potential in the second
half of FY12, thereby prompting an easing of monetary policy in early FY13. We
continue to expect 100 bp of rate cuts in FY13.  
What is India’s potential rate of growth? The answer to this question is particularly relevant
currently for at least two reasons—first, to know how much the recent slowdown in investment
demand and the lack of policy action in removing supply-side bottlenecks have impacted India’s
growth potential and medium-term earnings outlook. Second, with the sustained bout of high
inflation over the previous two years, how much of this is due to growth being above the
sustainable level.


                                   
Potential growth—some diminution due to
weaker investments
India’s potential rate of  growth has been rising
continuously since the late 1980s, primarily due to a
combination of structural reform driving technological
change, investment growth, and increases in the quality
and quantity of its labor force.
In early-2007, we had estimated potential growth at
8% due to rising productivity growth, high investments
and favorable demographics. At the time, our estimate of
potential growth was considerably higher than
conventional wisdom. Since then, of course, the
economy has endured several shocks including the
financial crisis. We dust off our potential growth
estimations from 2007 (see  India’s rising growth
potential, Global Economics Paper No. 152, January 22,
2007), and update them to take account of recent
developments. Growth potential is ultimately driven by
growth in inputs (particularly capital stock and labor)
and the efficiency with which these inputs can be
combined to produce output (see the procedure we have
used in our Appendix).  
We estimate potential growth
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  in  FY13  to  be  7.6%.
This is lower than the 8% earlier, but still a fairly
respectable level of growth, in our view. The moderation
in potential is largely due to the slowdown in gross fixed
capital formation, in part driven by policy bottlenecks
(see  India: Timing the bottom of the investment cycle,
Asia Economics Analyst 11/12, July 7, 2011).
Our results show that for every 1 percentage point
(ppt) fall in gross fixed capital formation (GFCF),
potential growth would fall by 0.1 ppt. Both the
production function approach and an OLS regression of
GDP growth on GFCF gave us similar results. The key
point is the importance of investment to potential growth,
and therefore the sensitivities show that a prolonged
slump in investment could significantly reduce potential
GDP. Thus far, the impact could be manageable but
                                             
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Our forecasts of potential growth are based on the estimated future
growth rates of the inputs: i.e., capital stock, labor inputs, educational
attainments and TFP.
without measures to spur it on, could cause a bigger
slowdown in potential.


Conclusions
Our analysis suggests that potential growth is coming off
due to weak capital formation. Thus far, the impact
appears low, but a prolonged slump could impact
potential further. Productivity continues to recover and
we think will likely be sustained given the enormous
scope for catch-up. The largely domestically-driven
services sector is driving  input, efficiency, and output
growth and imparts some resilience to the economy. We
provide some evidence to  back the robustness of
consumption demand—a rise in agricultural wages, and a
shift in labor from agriculture to services where
employee compensation is significantly higher. With
potential growth at 7.6% for FY13, we think that actual
growth will be below potential in the second half of
FY12, thereby prompting an easing of monetary policy
in early FY13.