Asia Economics Flash: India's Growth Potential-Lower But Still Tiger-Like

Asia Economics Flash
September 14, 2011

Goldman Sachs Global Economics, Commodities and Strategy Research at https://360.gs.com
Tushar Poddar tushar.poddar@gs.com +91 22 6616 9042 Prakriti Shukla prakriti.shukla@gs.com + 91 22 6616 9376 Vishal Vaibhaw vishal.vaibhaw@gs.com +91 80 6637 8602
Indias growth potentiallower but still tiger-like

Measuring Indias potential growth is important for two reasonshow 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 growthfavorable 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 demanda 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.
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What is Indias potential rate of growth? The answer to this question is particularly relevant currently for at least two reasonsfirst, to know how much the recent slowdown in investment demand and the lack of policy action in removing supply-side bottlenecks have impacted Indias 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 is a sustainable rate of growth where all inputs are working at near-to full capacity and there is no immediate inflationary pressure.
Goldman Sachs Global Economics, Commodities and Strategy Research
Potential growthsome diminution due to weaker investments

Indias 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 Indias 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 growth2 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
without measures to spur it on, could cause a bigger slowdown in potential. Exhibit 1: Indias potential growth has been increasing over time
% yoy 10.0
GDP growth
% yoy 10.0
8.0
8.0
6.0
6.0
4.0
4.0
Actual 2.0 Potential 2.0
0.0
0.0
Source: CEIC, GS Global ECS Research.
Exhibit 2: but would weaken going forward due to lower investments

ppt 10 9 8 7 6 5 4 3 2 1 0 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12E FY13E Percentage Point Contribution to Potential GDP Growth Average Year of School Net Fixed Capital Stock Potential GDP (% yoy) Employment TFP
Exhibit 3: 70% of GDP growth driven by investments and productivity

Percentage share of inputs in growth
FY06 FY07 FY08 FY09 FY10 FY11 FY12E FY13E
2
TFP
36 36 32 13 34 40 40 44
Capital Stock
30 32 35 43 36 31 26 25
Education Real GDP Employment Attainment Growth (% yoy)

18 18 18 25 15 15 17 16 15 14 14 18 15 14 16 15 9.5 9.6 9.3 6.8 8.0 8.5 7.3 7.8
Source: CEIC, GS Global ECS Research. 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.
Exhibit 4: Falling capital stock growth will likely drag down potential
% yoy 10.0 Net fixed capital stock Potential growth % yoy 10.0
Exhibit 6: More savings are being funnelled into investments by banks

% of GDP 55 Total assets: schedule commercial banks (rhs) 50 % of GDP 100
8.0
8.0 45
Bank credits
90
80 6.0 6.0 40 70 4.0

Forecast
4.0
35 60 30
2.0
2.0 25 50
0.0
0.0
20
40
Source: CEIC, GS Global ECS Research estimates.
Exhibit 5: More trade increases productivity growth

US$ bn 900 800 700 600 500 400 300 200 100 0
2002 2003 2004 2005 2006 2007 2008 2000 2009 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2001 2010 2011
Exhibit 7: Improved telecommunication consumption and spending

million 600 million 80 Internet subscribers (rhs) 70 500 Mobile phone subscribers 60
India's Total Trade (exports & imports)
% 55 50
As a share of GDP Total
45 40 35
400 50
300 30 25 20 100 15 10 0
40
30 200 20
10
Two of the three key ingredients for potential growthdemographics and productivity growth are still in place. We discussed the contribution of demographics to growth extensively in an earlier paper (see Indias Rising Labour Force, Global Economics Paper No. 201, July 28, 2010). For productivity growth, we think that a majority of the growth drivers are still in place. Openness to tradeas Indias trade linkages increase, access to technology, learning-by-doing, and competition increases efficiency levels. The share of trade in GDP has continued to grow. Financial sector growthmore savers have access to banks which are channelling these more efficiently to investments, thus increasing productivity of capital (financial deepening).
US$ bn 60 Per capita (rhs) 50 Total
IT Spending
US $ 50
40
40 30 30 20 20
10 10
0 2003 2004 2005 2006 2007 2008 2009
Source: WDI, Haver, CEIC, GS Global ECS Research.
IT and mobile phone penetrationthese continue to raise the technological frontier of the economy, thus enabling faster productivity growth. Infrastructurebetter roads, power, ports, and airports can increase productivity growth in the economy (see Indias CAN Afford its Massive Infrastructure Needs, Global Economics Paper No. 187, September 16, 2009). UrbanizationOur estimates show that labor is 3.5 times more productive in manufacturing and 5 times more productive in services compared to agriculture. Ongoing urbanization, which leads to this sectoral shift, can increase overall productivity growth as a result.
Exhibit 8: Greater infrastructure investment is key to productivity growth

US$ bn 300
Infrastructure Investment (both public & private)
% 11.0
Projections
250 US $ bn 200 % of GDP (rhs) 9.0 150 8.0 100 10.0
7.0 50
0 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17
6.0
Total factor productivity fell during the crisis, but has recovered since, albeit not to its pre-crisis highs. This may reflect a number of factors including lower investment (primarily in infrastructure), a higher base for technology (for instance, mobile and phone penetration may not grow at the same rate as pre-crisis), or trade flows being weaker. That said, we think that productivity growth will likely be sustained going forward. Our estimates for productivity growth are fairly reasonable at 2.6%, below the pre-crisis average of 3.2%. Our potential growth estimations depend heavily on our assumptions of the dataparticularly the pace of productivity growth and investment growth. We therefore would not like to emphasize the point estimate, but the confidence interval is about 7.4%-7.8%, which in and of itself is not surprising. The key point is that growth potential is significantly influenced by the investment cycleit was rising during the boom years of 2003-2007, but has come down in the current investment slowdown.
Source: Planning Commission, GS Global ECS Research.
Exhibit 9: Due to continued urbanization, labor productivity is rising

% of total 30 29 28 27 26 25 24 23 22 21 20 India's Urban Population
Source: WDI, Haver, GS Global ECS Research.
Services driving overall growth

We broke down the production function by sector to look at investment and productivity growth. Services sector productivity and growth remained largely unaffected by the financial crisis. It remains the key driver of economic growth (% of GDP). Valueadded growth and productivity growth remain the highest in the services sector, while investment growth has remained strong. It is also showing the highest growth in labor. We measure labor efficiency by dividing sectoral value-added by the number of labor-hours used in production. The resilience of the services sector to the financial crisis augurs well for GDP growth in any downturn. Growth in the services sector also reflects the resilience of domestic demand and the fiscal stimulus during the crisis.
4
Exhibit 10: A positive output gap impacts Inflation after a lag

%chgqoq,sa 6 5 4 3 0.02 2 0.00 1 -0.02 0 -1 -2 2006 2007 2008 2009 2010 2011 -0.04 -0.06 -0.08
WPI core inflation Output gap based on the Industrial Production Index (RHS) %,3mma
0.10 0.08 0.06 0.04
Exhibit 11: Sustained high labor-productivity in services

% yoy 9.0 Agriculture 8.0 7.0 6.0 Industry Services Labor Productivity (Real output per hour of all persons)
Exhibit 12: Agriculture has a disproportionately high share of labor, but low capital stock and output share
% 120.0 Agriculture 100.0 Services Industry
Percent Share in GDP Growth
80.0 5.0 4.0 3.0 40.0 2.0 1.0 0.0 -1.0 FY06 FY07 FY08 FY09 FY10 -20.0 2006 2007 2008 2009 2010 2011 20.0 60.0
0.0
Our results suggest that agriculture has seen a robust increase in investments, but is not showing a commensurate increase in output. Productivity of capital in agriculture has been very low. Not only is employment stagnant, productivity of labor is also low. That said, as we show below, wages in agriculture have been rising faster than output contributing to greater consumption demand and also a more equitable distribution of resources. Industry saw a large increase in fixed asset investment before the crisis, which was also accompanied by an increase in productivity. The decline during the crisis was also sharp, and since then there has been a period of recovery, albeit shallow. There has been little employment growth in manufacturing, therefore most of the increase in output has come from capital investments and rising productivity.
Percent Share in Total Capital Stock

% 100.0 90.0 80.0 70.0 60.0 50.0 40.0 30.0 20.0 10.0 0.0 2006 2007 2008 2009 2010 2011 Agriculture Services Industry
Percent Share in Total Employment

% 100.0 Agriculture Services Industry
Share of employeesgrowing in line with GDP

Since 2005, the share of income of labor and capital has not changed significantly on an aggregate basis, showing an equitable distribution of the gains from growth. Therefore, the share of compensation of employees in GDP remains at 30%, while operating surplus and mixed income remains at about 60%. The compensation of employees in agriculture is rising, suggesting support for rural demand. As per our earlier findings, agriculture remains mired in weak growth and productivity, but the rising compensation of employees suggests that wages have been going up. This is partly due to the National Rural Employment Guarantee Act (NREGA). Since 54% of the labor force is in agriculture, this will support consumption demand in rural areas.
5
80.0
60.0
40.0
20.0
0.0 2006 2007 2008 2009 2010 2011
Share of wages in services has been falling. Both value added and productivity growth in the services sector has been high, as discussed above. Operating surplus has been rising, and since a majority of the listed firms are in the services sector, this augurs well for earnings growth.
Exhibit 13: Overall labor-share of output is constant, but in services is showing a decline
% of sectoral GDP Compensation of employees Agriculture 40.0 Manufacturing Services All-India 35.0
Exhibit 14: India has one of the lowest labor shares in the region
%
Compensation of Employees as a Share of GDP (2009)*
Korea
61
30.0
China
47
25.0
Thailand
20.0
41
15.0
India
10.0 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10
30
10
20
30
40
50
60
70
*India's figure is for FY10
Finally, Indias labor share of income will rise as labor shifts from agriculture to servicesa trend we are witnessingand thus boosting consumption demand.
Exhibit 15: Wages of agricultural workers are rising

As % of gross value added 15.2
Compensation of Employees in Agriculture
15.1
Conclusions
15.0
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 demanda 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.
14.9
14.8
14.7
14.6
14.5 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10
Exhibit 16: How efficient is capital? Indias capital efficiency has increased after the crisis (ICOR has fallen)
% 7.0
Incremental Capital-output Ratio (ICOR)
6.5 China 6.0 India Indonesia
5.5
5.0
4.5
4.0
3.5
3.0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Source: CEIC, Haver, GS Global ECS Research.
Appendix: Estimating productivity and potential growth sensitivity

I. Productivity and efficiency estimates In accounting for the sources of growth, we use the Cobb-Douglas production function to estimate the contribution to growth from physical and human capital accumulation, as well as productivity gains. The measure of productivity used is total factor productivity (TFP), measured as the residual part of economic growth that is not accounted for by the accumulation of physical or human capital.3
Y AK ( L E ) (1 )
Where Y: Total (real) gross domestic product (GDP) A: Total factor productivity (TFP) K: (Real) net physical capital stock (NFCS) : Factor share of capital (1- ): Factor share of labor L: Labor employment E: Labor quality index based on average years of education of the population aged 15 years and above. For individual sectors, the same procedure has been adopted. Factors shares were assumed to be 0.4 for agriculture sector, 0.3 for industry sector and 0.3 for the services sector. The weighted-average of factor-shares (0.33) was used for the all-India analysis. Since net capital stock numbers were not available for FY11, we calculated its average past ratio with gross fixed capital formation (GFCF). The available numbers for FY11 for GFCF were then used to get NFCS figures. To measure the efficiency of labor, sectoral value-added was divided by the number of labor-hours used in production. We also calculated Incremental Capital-Output ratio to measure the efficiency of capital using the World Bank formula of investment in the past year divided by change in GDP.
For a detailed explanation of the technique used, refer to Indias Rising Growth Potential, Global Economics Paper No: 152, January 22, 2007.
Exhibit A1: Net fixed capital stock closely tracks gross fixed capital formation
% yoy 25.0 Gross fixed capital formation Net fixed capital stock (rhs) 20.0
Forecast
% yoy 12.0
10.0
15.0 8.0 10.0 6.0 5.0 4.0 0.0 2.0
-5.0
-10.0
0.0
Source: CEIC, GS Global ECS Research estimates.
We also attempted inter-country comparisons of labor-compensation as a proportion of GDP. For this, compensation of employees (COE) at current prices was divided by the GDP at current prices of the respective countries. For India, sectoral comparisons of this ratio have been calculated as COE of the sector (at current prices) divided by the GDP (at current prices).
II. Measuring potential GDP growth Potential output was estimated using the production function described above. For this, cyclical changes in the inputs were removed (using HP filter) and the trend growth of inputs was obtained. In addition, labor input was adjusted by the NAIRU (non-accelerating inflation rate of unemployment) calculated using the average daily-status unemployment. We inserted the de-trended growth rates of inputs into the above production function to calculate the potential output growth. 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. Forecasts for labor assume that the labor-force will grow at the same rate as past growth in working-age population. The inherent assumption is that the labor force will grow at same rate as the working age population. Capital stock forecasts are based on our forecasts of GFCF in FY12 and FY13. Education forecasts also assume trend growth. Productivity forecasts are based on the average of past 5 years TFP growth.
III. Measuring sensitivity Sensitivity of potential GDP growth to GFCF was also examined as an alternative to the production function approach. An ordinary least squares (OLS) regression of the two series showed a coefficient of 0.1 on the regressor (GFCF) and a significant regression output.
IV. Data sources The data source for labor-force is The World Bank and for capital input is Central Statistical Organization (CSO). Sectoral labor-force estimates were calculated by us using employment ratios from CSO. The daily-unemployment rates used in the calculation are obtained from the NSSO quinquennial employment surveys. For sector labor-productivity calculation, usual principal status unemployment estimates have been used instead. Estimates of average years of schooling were obtained from Barro and Lee (2010)4 and have been assumed to be the same across sectors.
http://barrolee.com/
We, Tushar Poddar, Prakriti Shukla and Vishal Vaibhaw, hereby certify that all of the views expressed in this report accurately reflect personal views, which have not been influenced by considerations of the firm's business or client relationships.
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Asia Economics Flash

September 14, 2011

Indias growth potentiallower but still tiger-like

Goldman Sachs Global Economics, Commodities and Strategy Research