Managing a trillion dollar economy

Some time in 2008, India will join the select group of countries with a trillion dollar economy. The journey to the trillion-dollar GDP mark has been a long and arduous one. The second trillion to India?s GDP could be added in less than eight years, if we average a growth rate of 7-8% and inflation rate of 4-5%. Within the next decade or thereabouts, we will be among the top five economies of the world in nominal terms and the third-largest if our GDP is measured in terms of purchasing power parity. India has already begun adding more than $100 billion to its GDP each year?more than the GDP of a large number of small countries.

Foreign investors are pouring money into India precisely because they expect this outcome. The next decade will be the defining one for India, when it would join the ranks of the big boys. Over the next decade, India?s investment will triple from the current $250 billion per annum to around $700 billion per annum. Our merchandise exports could multiply six times to reach $600 billion per annum and if we add to this our services exports, our total presence in foreign markets could be in the region of around a trillion dollars by 2015.

The short point is that India is on the verge of graduating from a small economy into a large one. The scale of our achievements is about to change, but also about to change is the scale of our challenges. The issue is whether our policies and institutions are equipped to deal with this change. The question becomes all the more critical as, hitherto, we had been used to dealing with a regulated and mixed economy. Reforms over the past decade and a half have transformed our economy, which is now increasingly being driven by market forces, both local and global.

The first implication of the economy becoming market-driven is evident. The journey from the first trillion to the second trillion of GDP may not be smooth and could be volatile. Prior to the reforms, the ups and downs in our economy were driven either by monsoons or external shocks. However, as the dominance of market forces increases, we will have to learn to deal with business cycles.

In the mid-90s, our economy responded well to reforms and the GDP growth rate had crossed the 7% mark. While the farm sector had remained sluggish, both industry and services sectors had shown double-digit growth. By 1998-99, the euphoria had vanished and the ensuing slump had taken most by surprise?few had anticipated the downturn of the cycle. This had happened because, in their enthusiasm, private investors had created overcapacity. Once that was discovered, enthusiasm was replaced by pessimism?leading to a fall in investment. In just one year, 1995-96, private investment had jumped up by more than two percentage points to reach 16.7% of GDP.

As the resulting overcapacity was discovered, private investment slump-ed and by 1998-99 had fallen to 15.1%. The impact of the slump was all the more pronounced, as during the 90s, attempts to control the fiscal deficit took the form of cuts in public investment that fell from 9.2% of GDP to 6.5% of GDP by 2000. Therefore, public investment could not counter the recessionary impulse released by contraction in private investment.

This could happen again and prolong our journey to the two trillion GDP mark. As the economy becomes bigger and more market-driven, the fact of the business cycle would have to be accepted. Decisions taken by millions of private investors are bound to produce outcomes that are different from expectations and create mismatches between supply and demand. Thus, investor enthusiasm and overcapacity would alternate with cutbacks in private investment and slumps.

It is now fairly well established that fiscal policy is a better tool to deal with slumps than monetary policy. The latter is better equipped to manage inflation or asset prices rather than expanding investment. Therefore, as the economy becomes increasingly market-driven, fiscal policy would have to emerge as a stabilising force against slumps. This would require sustained increases in public investment.

As India aspires to join the world?s leading economies, it must recognise that our share of public investment in total investment is much lower than that in other economies and needs to be raised substantially. This would be the best antidote against business cycles. The good news is that Mr Chidam-baram has already recognised this fact and increased the share of public investment. As fiscal responsibility commitments reduce the revenue deficit, it is expected that public investment would go up in good measure, which would sustain high growth rates.

However, as we increase public investment, it is apparent that new institutional mechanisms to raise the efficiency of those investments would have to be put in place. We all know that governance systems of the past have failed to maximise outcomes and emphasis has been on monetary rather than physical targets. We do not know how many houses have been built over the last three decades under the Indira Awaas Yojana and how many survive, or whether the same house is being built again and again. The same could be said of rural roads or watershed development or drinking water supply. We have the technology but no mechanism to collect verifiable information on physical targets. Here again, Mr Chidam-baram has taken the right initiative to put in place an outcome budget. We need institutions of governance that can move towards achieving private efficiency in public investment. The economy would then be on a far more sustainable path to higher growth.

The writer is an advisor to Ficci. These are his personal views