Why investment and productivity is key to India’s GDP growth

Updated: Feb 23, 2018 5:41 AM

The experience of similar economies shows that india needs to boost its investment growth and labour productivity to grow at 8%-plus for a sustained period

GDP growth, india GDP growth, total economy database, GDP growth club, total factor productivity, Japan, south korea, European countries, japanA simple growth decomposition exercise indicates that output growth depends on both growth in the labour force and an increase in labour productivity.

Samiran Chakraborty

An emerging economy aspiring to grow at a sustained high GDP growth rate might gain from lessons offered by the historical growth patterns of similar economies. It is true that the initial conditions and growth drivers could be diverse for different economies but pooling together the experience of a large set of countries for a long period throws up some common trends. The total economy database (TED) of the Conference Board provides us with a common dataset to undertake such an analysis where we focus on what are the primary drivers of a high growth economy. For our analysis, we chose a panel of 26 countries and annual growth data from 1950 onwards, with a good mix of both developed and developing economies.

A simple growth decomposition exercise indicates that output growth depends on both growth in the labour force and an increase in labour productivity. If we assume that growth in the labour force is mostly exogenous, then labour productivity can be altered by measures that improve human capital formation (education, skills, etc), increase the capital available (machinery, equipment) for each worker, and increase the overall efficiency of production embodied in total factor productivity (TFP).
Following this framework, we choose growth in labour productivity, growth in investment, and growth in TFP as the primary drivers of growth in any economy and try to identify threshold levels of these parameters associated with high levels of GDP growth in the past. India’s aspiration is to grow at double digits. For our analysis, we particularly focus on the 8%+ GDP growth club.

Investment growth

In 46% of our panel data points, an 8%+ GDP growth rate was associated with a more than 10% growth in investments in that year. Conversely, if a country achieved 10%+ investment growth, then in 42% of cases, the country was able to reach at least 8% GDP growth. The possibility of recording 8% GDP growth recedes substantially (to 22%) if investment growth is even a little lower, i.e., between 8 and 10%. Within our sample countries, Japan and South Korea have consistently recorded 10%+ average investment growth over four decades (between 1950s and 1980s). China achieved the same feat from the 1980s onwards. Even smaller countries like Vietnam, Indonesia and Singapore had several decades of 10%+ investment growth, which led them to a faster GDP growth trajectory.

India’s investment growth has been in the range of 5–8% for most of the years between 1950 and 2003. The average GDP growth ranged between 3–7% over this period. Even for our larger sample of countries, 5–8% investment growth led to 3–7% GDP growth in 70% of cases. After 2005, India experienced an average investment growth rate of 11% for 7 years, propelling GDP growth to average > 8%. After 2011, investment growth started moderating and the latest print of 6.5% in 2016 leaves scope for improvement.

Labour productivity

Labour productivity, defined as output per employed person, grew in excess of 6% for the high GDP growth economies in our panel—in 75% of the cases, GDP growth exceeded 8% if labour productivity growth was more than 6%. GDP growth mostly stays in the 5–8% range if labour productivity growth is a little lower, i.e., between 4 and 6%. China experienced strong growth in labour productivity after the 1980s through a mix of better capital deepening and higher TFP. Japan had two decades of average labour productivity growth of 8% in the 1950s and 1960s. Postwar reconstruction efforts increased labour productivity in some of the European countries (Germany, Italy, Spain, etc.) beyond the threshold of 6%. Some smaller countries like Israel and Saudi Arabia also witnessed a couple of decades of average labour productivity growth beyond 6% in the 1950s and 1960s.

India’s labour productivity growth averaged a dismal 1.7% in the 30 years between 1950 and 1980. It improved to an average of 3.8% in the next 20 years and shot up to an average 8% between 2005 and 2011, which were also India’s best growth years. Since 2011, labour productivity growth has started decelerating and the 4.3% growth posted in 2017 was much lower than what is required to sustain GDP growth in excess of 8%.

Total factor productivity

In our sample, we find that 3% growth in TFP is a good threshold to explain high GDP growth economies. In 60% of the economies which experienced GDP growth of more than 8%, TFP growth was in excess of 3%. Conversely, TFP growth higher than 3% ensured that in at least 50% of the cases, the GDP growth for that year exceeded 8%. If TFP growth was between 2–3%, then in 66% of the sample points, GDP growth was between 3–7%. Sustained average TFP growth of more than 3% was achieved only by China in 1980-2010. Some other countries have sporadically achieved this feat—i.e., Japan (1960s), Germany (1950s), Brazil (1950s and 1970s), and Turkey (1950s and 1960s)—but sustaining this over a longer period has been a difficult task. After the Great Financial Crisis, no country in our sample has achieved average TFP growth of more than 3%.

Low efficiency in production has been one of India’s main growth challenges. TFP growth was just above 1% even in the 1980s and 1990s, leading to GDP growth getting stuck in the 5–6% range. It improved to an average of 2.5% in the boom years of 2005 to 2011 but has again slipped to below 2% in the 5 years after 2011. India has never achieved consistent 3% TFP growth for a reasonable period, demonstrating why productivity improvement is likely to be such an important component of achieving high GDP growth.

A simple decomposition of India’s GDP growth reveals that the labour-intensive growth until the 1980s is gradually getting substituted by a more capital-intensive growth with TFP sharing the burden. This progression needs to be continued to improve the quality and durability of GDP growth.

Convergence of growth

Convergence of economic growth suggests that relatively poorer economies are likely to grow faster than richer ones. The TED database provides the per capita GDP of different countries adjusted for purchasing power parity (PPP) and converted to 2016 US dollar terms. We find that for countries who have registered 8%+ GDP growth in a year, their per capita income was less than $5,000 in 33% of the instances and $5,000-10,000 in another 28%. This implies that more than 60% of the high-growth instances were for countries having less than $10,000 per capita income even after a PPP adjustment. However, there are also proportionately large instances of low per capita income economies stuck in a low-level equilibrium trap of relatively slower growth persisting for a long period.

Most of China’s high-growth decades (1980–2010) have been with per capita income at less than $10,000. Even some of the East Asian economies (Korea, Thailand, Malaysia, Vietnam etc.) have grown the fastest when their per capita incomes were relatively low. Countries like Japan and Israel have seen their GDP growth rates dropping from more than 8% in the 1950s and 1960s to 6% or below as their per capita income has grown substantially beyond $10,000.

Saudi Arabia and some of the post war reconstructing European economies are exceptions, growing at more than 10% despite much higher per capita income. On the other hand, countries like Indonesia, Philippines and Turkey haven’t grown at more than 8% on a sustained basis despite per capita income lagging much below the $10,000 mark.

India’s per capita income (~$7,000 in 2017, PPP adjusted, converted to 2016 US dollars) is one of the lowest amongst our sample countries. This suggests that India could have several years of strong growth before it reaches even the $10,000 per capita mark. In that context, the convergence of growth argument is in India’s favour but it needs to avoid the perils of getting stuck in a low (or mid) level equilibrium trap.

Author is Chief economist (India), Citigroup

(First of a two-part series)
Edited excerpts from Citi GPS report Securing India’s Growth Over the Next Decade

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