Macroeconomic theory states that a fall in aggregate demand leads to recession, causing the actual output to drop below the potential (or trend) output. However, this effect is temporary. A recovery follows recession causing the actual output to bounce back to the potential and the potential itself if not affected significantly by recession[i].
An examination of India�s potential output growth data however puts this macroeconomic theory in question.
Potential output can be broadly defined as the maximum amount of goods and services that an economy can produce at full capacity. It is often referred to as the production capacity of the economy. In the macroeconomic sense it is the output that is defined as the �maximum production without inflationary pressure�[ii]. It is that level of output at which there is no pressure for inflation to increase or decrease.
While there are several techniques to estimate potential output, a simple statistical smoothening procedure called the Hodrick Prescott (HP) filter is used in this analysis. The HP filter has become popular because of its flexibility in extracting a trend from macro- economic data. Results from the HP filter technique point that while potential output traced an increasing trajectory since FY72 to FY07, it started reversing since the global financial crisis (FY07) and there has been a huge decline ever since(Figure 1). Potential output growth which peaked at 7.8 percent in FY07 has fallen to 5.7 percent as of FY14. This has put to question the recovery theory that was talked about in the beginning- not only is the actual growth way below the potential, the potential growth itself has seen a perceptible decline since the crisis.
FIGURE 1: INDIA�S POTENTIAL GROWTH ON A DECLINING TRAJECTORY SINCE FY07
Source: Central Statistical Office, Note: * Real GDP at Factor cost
In the context of Harrod -Domar Model which views investment and Incremental Capital Output Ratio (ICOR, utilization rate) as the sole determinants of the potential output, much of the decline in potential growth can be explained through the declining investments and increasing ICOR. However, if we look at the growth accounting framework, it explains economic growth by decomposing it into contributions of labour, capital and a residual measure of gains in efficiency called the Total Factor Productivity (TFP)[iii].
Even though recent studies[iv] (Anand et al. 2014) have shown the rising contribution of TFP in explaining economic growth, we stick to the Harrod Domar model in explaining the potential growth decline.
Investments as measured by Net Fixed Capital formation (Gross fixed capital formation adjusted for inventories) have declined both in growth terms as well as a percentage of GDP (Figure 2). NFCF growth which averaged 13.6 percent between FY03 to FY08 fell to an average 7.3 percent in the next five years. As compared to a growth of 16.1 percent and 25.7 percent in FY04 and FY05 respectively, NFCF contracted by 0.2 percent in FY14 after growing by a mere 1.4 percent in FY13. As a percent of GDP too, the share of NFCF has declined significantly. NFCF as a percent of GDP fell to 17.6 percent in FY14 as compared to the peak (highest ever) 29.3 percent in FY06.
FIGURE 2: NET FIXED CAPITAL FORMATION ON A DECLINE
Source: Central Statistical Office
Incremental Capital Output Ratio (ICOR) or capital efficiency is the other factor responsible for the decline in the potential growth. ICOR measures the fixed investment required to produce an additional unit of output. Lower the ICOR, higher the productivity of capital and vice- versa. ICOR which averaged to 4.1 in the pre- crisis high growth phase (FY04- FY07) rose to an average 5.9 for FY10- FY13. In FY13, ICOR rose sharply to 8.5 reflecting a massive decline in capital efficiency.
Thus, the slowdown in India�s trend growth in the last few years was led by the declining investments and capital efficiency. This decline was a result of the heightened regulatory and policy uncertainties and delayed project approvals and implementation and structural weaknesses. In order to boost the potential to sustainable pre- crisis growth there is a need for addressing supply bottlenecks and implementing structural challenges particularly in the agriculture and power sectors and creating an investment- friendly environment with faster approvals and implementation. Only these can help in driving in investments and reducing the capital inefficiency which need to be brought to pre-crisis levels to give potential growth a fillip.
[i] Ball M L. Long Term Damages from the Great Recession in the OECD countries, NBER, 2014
[ii] Okun, Arthur,M. The Political Economy of Prosperity. Washington, DC: Brookings Institution, 1970
[iii] In the conventional growth accounting framework which uses a Cobb Douglas production function Total Factor productivity is calculated as the Solow Residual (A):
, where: Y = total output, L = labor input, K = capital input and A = total factor productivity which embodies the efficiency with which factor inputs are used, such as technological progress and other components.
[iv] Anand R, Cheng K, Rehman S, Zhang L. Potential Growth in Emerging Asia. IMF, 2014