Suman Bery: Supplying demand

Careful analysis suggests the supply side of the economy is still capable of sustaining nine per cent growth

Suman Bery / Aug 31, 2012, 00:11 IST

Faithful readers of this column will recall my decision earlier this year to shift focus from issues in the domestic economy to India’s place in the world. I am deviating from that principle this month. I was recently asked to make a presentation on India at an international conference, and this prompted me to look carefully at the Indian numbers once again. The key question of interest to the audience was why Indian growth had slowed, and when it might revive.
To non-specialists this may seem a simple, indeed trivial question to answer; but in reality, much of the answer is based on conjecture. What the statisticians are able to provide us with, through the national accounts, is at best an account of what did happen. It is left up to theory, modelling and judgement to explain why the economy behaved in the way it did. A brief review of national accounts concepts is perhaps helpful to illuminate the discussion that is to follow.
The national accounts are prepared from several perspectives, which are then used to cross-check each other. It is, therefore, rightly called the “system of national accounts” (SNA). Within the SNA the “product accounts” refer to flows of goods and services in the economy and are presented both from the supply side (usually called “industrial origin”) and from the demand side.
The broad categories on the supply side are the familiar ones of agriculture, industry (including both manufacturing and construction) and services. Final demand is represented by consumption, gross capital formation and by “net exports”, the difference between exports (of both goods and services) and imports. There is a third set of balances, which track the financial flows associated with these transactions. These financial accounts generate the well-known result that domestic capital formation (fixed investment, change in stocks and acquisition of valuables, such as gold) not financed by domestic saving generates a current account deficit in the balance of payments, which in turn is financed by foreign saving.
In both advanced countries and emerging markets, long-term growth is determined by developments on the supply side (capital, labour and productivity). These determine the path of what is called “potential output”. However, there can be significant deviations from this long-term path. It is only with hindsight – and the application of some fairly muscular statistical analysis – that one can definitively separate cycle from the underlying trend. In the industrial countries, these fluctuations are usually associated with developments in aggregate demand. As the present financial crisis, the travails of Japan and the Great Depression of the 1930s all demonstrate, disruptions in aggregate demand can last for sustained periods of time, and such episodes are most often associated with failures in the banking and credit system.
By contrast, in emerging markets, short-term fluctuations around the long-term trend are more conventionally associated with supply bottlenecks: food, fuel, raw materials and foreign exchange. Fiscal, monetary and exchange rate policy do have a role to play in demand management, but the transmission channels are more opaque and less well-developed and less well-understood than in the mature countries. This makes macroeconomic analysis in emerging markets a more challenging task than in advanced countries.
Turning finally to numbers, a most valuable recent source is the Economic Outlook* put out earlier this month by the Prime Minister’s Economic Advisory Council (PMEAC), chaired by Dr C Rangarajan, a body with which I was privileged to be associated until last year. The PMEAC’s semi-annual published reports provide an extremely useful blend of analysis, interpretation and forecast in a compact format. In addition, the relatively few tables in the report are very well designed. They present key ratios in a long enough series to reveal the underlying structural changes in the economy while also helping illuminate the shorter-term fluctuations.
Table 1 in the Economic Outlook provides the reader with essential data by industrial origin, while its Table 3 provides essential analysis of the demand components in the economy. The overall growth story is reasonably familiar: three golden years from FY06 (2005-06) till FY08 with growth in excess of nine per cent; the slowdown to 6.7 per cent in FY09; two slower but respectable years in FY10 and FY11 with growth around 8.5 per cent; and then the unexpected slump to a projected 6.5 per cent in the fiscal year just ended. It is more interesting, therefore, to focus on non-agricultural growth, where, as the Economic Outlook rightly points out, the main slide has been in manufacturing and in construction. Manufacturing growth in particular has dwindled from 9.7 per cent in FY10 to an estimated 2.5 per cent in FY12.
It seems unlikely that this deterioration in manufacturing primarily reflects supply constraints (although land, power, skilled labour and infrastructure continue to bedevil the sector), so it is worth glancing at the demand data presented in Table 3. Much of the attention, in the Economic Outlook and elsewhere in the press, is on trends in gross domestic fixed capital formation (structures and machinery). The rise in this ratio, from around 23 per cent of GDP in FY01 to 33 per cent in FY08 was one of the most heartening aspects of the boom. Amazingly, for much of this period the domestic savings rate kept pace, rising to a towering 37 per cent in the banner year of FY08.
Fast growth seems, therefore, to have been good for both saving and capital formation, in part by strengthening the public finances. Even inflation was on a downward path till FY08. Based on the conventional indicators, this was not an unsustainable boom. Indeed, the usual signs of overheating (rising inflation, widening current account deficit) have become manifest as the economy has slowed. This is even clearer in the product accounts: in a recent report Citi shows that net exports have widened from -3.2 per cent in FY06 to an estimated -7.4 per cent in FY12, representing a massive withdrawal of net demand, even though exports have been strong.
I hesitate to draw firm policy conclusions from these numbers, except to note that FY09 subjected the economy to the triple shock of a drought, the slowing of global demand and the political transition to UPA-II at home. These shocks have exacted a continuing toll on the fiscal accounts, inflation and the investment climate. My main takeaway is that the supply side of the Indian economy remains capable of sustaining nine per cent growth, and that worries about overheating should not prevent us from trying as the global environment improves.

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The writer is Chief Economist, Shell International.
These views are personal.
*http://eac.gov.in/reports/eco_report1708.pdf