With GDP growth accelerating to 9.5% during the last two years, policymakers are optimistic that the Indian economy?s expansion is sustainable. By the latest mid-term review, this shift to a higher growth path is attributable to a change in domestic and global perceptions of the medium-term growth potential of the economy. This is reflected in a sharp upswing in domestic investments and foreign direct inflows. But concerns about whether India is pushing against the limits of its productive capacity continue to linger among economists. Part of the problem has been the absence of reliable up-to-date estimates of potential output growth. However, a recent IMF working paper by Hiroko Oura addresses this lacuna and in the process also clarifies differences in assumptions made by various researchers in estimating India?s growth potential.
Given actual capital stock growth in 2005-06 and different assumptions of economists like Dani Rodrik and Arvind Subramanian, Tushar Poddar and Eva Yi, Barry Bosworth and Susan Collins and the IMF?s World Economic Outlook, India?s potential output growth in 2006-07 ranges from 6.8% to 8.8%. Oura then excludes two of these studies as they make somewhat extreme assumptions on the contribution of human capital. The range of potential output growth accordingly narrows down to 7.4% to 8.1%. As India?s actual growth of 9.4% exceeded these estimates, questions of overheating naturally surfaced.
Oura then makes medium-term simulations starting 2007-08 again on the parametric assumptions of these four studies, with the projections reflecting the actual growth rate of 9.4% in 2006-07, investment rate of 35.3% and actual capital stock growth in 2005-06. On this basis, India?s medium-term potential growth ranges from 7.3% to 9.5%. Again excluding two studies for their human capital assumptions, narrows the range to 8% to 9%. The upshot is that India?s potential growth has shifted upwards as it is investment-led and productivity-driven.
But this transition is not without its challenges. India?s investment rate is already high by Asian standards, and it?s hard to maintain the efficiency of investment?which may face a cyclical decline. Also, productivity gains could be volatile. Sustaining growth calls for deeper economic reform.