Is the Indian economy hitting its speed limit a little too early in the recovery cycle? The recent signs have been ominous.

The monetary policy committee said in its statement earlier this month that the output gap has virtually closed, or that the economy is growing close to its potential. It did not give an explicit estimate about what that magic number really is. However, the sharp increase in core inflation in recent months is one indication that the output gap has narrowed to a sliver. Even the decline in headline inflation in July was driven by food prices rather than core inflation. Capacity utilization is also climbing for the first time in several years, if one goes by the enterprise surveys conducted by the Indian central bank.

The International Monetary Fund (IMF) has provided an estimate in its recent annual health check-up of the Indian economy. The multilateral lender has used several statistical filters to conclude that India’s potential growth was 7.3% in fiscal year 2018. It adds that potential growth is likely to increase to 7.75% in the coming years, as the recent economic reforms make an impact.

The medium-term estimate of potential growth will be revisited once government statisticians release a longer gross domestic product (GDP) series under the new methodology in November. “There remains considerable scope for potential output to increase even further—above 8 percent—though important additional reforms in the areas of land and labour, which could generate a rebound in investment, would be needed, along with simplifying and streamlining the GST (goods and services tax). To date, progress on such reforms has been limited and weak credit growth is holding back investment growth," the IMF added.

Textbook neoclassical growth theory tells us that economic growth depends on three ingredients—increase in capital stock, increase in the labour force and productivity growth. The increase in capital stock—aka investment—has been muted in recent years because of excess capacity as well as the twin balance sheet problem. There are now some signs that the investment cycle is turning, a possibility on which this column had stuck its neck out in April 2017 (bit.ly/2MhJAUM). The point here is that a robust recovery in investment activity will be needed if India’s ability to grow rapidly without breaching the inflation target is to be a reality.

The IMF economists say that the recent uptick in potential growth despite the investment slowdown has been driven by productivity gains. They have not provided a detailed analysis of why productivity growth has emerged as the most important driver of economic growth over the past few years.

There are usually two ways productivity increases across an economy. The first is when people shift from low productivity to high productivity sectors. The classic example here was the shift of millions from farms to factories across East Asia during its economic boom. The second possibility is when productivity increases as resources are reallocated within sectors, from low productivity to high productivity enterprises. The prospect of formalization of Indian manufacturing thanks to GST can be an important catalyst of intersectoral productivity gains.

The issue of potential growth can sometimes seem to be an irrelevant obsession within the economics community, the sort of activity that leaves the rest of the world cold with disinterest. Potential output—as well as the equilibrium interest rate—is an unobserved variable that has to be estimated. The usual statistical techniques have limitations; the estimates they generate are often affected by the most recent readings of economic growth. In the case of a country such as India that is undergoing structural change, there are too many structural breaks in the data. So, the estimates of potential growth are often more considered judgements than exact measurements.

Why then should they matter? This is a valid question. There are two possible answers. First, the estimates of potential growth can give the political leadership a good idea of how fast an economy can grow without sparking off an inflationary fire. A low potential growth estimate should also hopefully lead to an internal debate about which economic reforms are needed to ease problems on the supply side.

Second, macro policy can go off track without good estimates of potential growth. India saw this at the beginning of the decade. Policymakers continued to stimulate the economy through high fiscal deficits as well as low interest rates even as inflation reached double digits, partly because of the implicit assumption that Indian potential growth was still at its pre-2008 highs rather than declining. Most would remember the macro mess that led to the run on the rupee five years ago.

India saw a sharp debate on potential growth a little more than a decade ago, especially after the publication of two papers by Barry Bosworth and Susan Collins, followed by a third one that the two American economists wrote in collaboration with Arvind Virmani. Some of the technical details were numbing, but the debate had profound policy implications. India needs a new version of the debate right now. It would be far more useful than airy hand-waving about double-digit growth.

Niranjan Rajadhyaksha is executive editor of Mint.

Comments are welcome at cafeeconomics@livemint.com. Read Niranjan’s previous Mint columns at www.livemint.com/cafeeconomics

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