Are they correct? The standard approach to growth forecasting, at least in India, is to predict growth rates for the components of the three key sectors - agriculture, industry and services - using some assumptions about the various factors that drive their performance, and then simply combine them. An alternative approach focuses on the critical "factors" of production land and labour, the efficiency of their utilisation and finally total factor productivity (TFP), the somewhat mysterious component that complements these factors. This approach could give more useful insights into the likely trajectory of growth. It might also help to take stock, at this stage, of the "potential output" or PO (that can be used interchangeably with output growth) based on the changes in these factors of production.
Let us start with the latter. A classic definition of PO is "maximum production without inflationary pressure" provided by the well-known American economist Arthur Okun. If the economy is pushed beyond this level or growth rate, inflationary pressures begin to build up. Thus an important question to ask at this stage is the following: "what growth rate that is compatible with moderate levels of inflation can we sustain at this stage?"
But first, what determines PO? To get to the point quickly, there are two principal drivers of potential output - first, the utilisation rates of each of the factors of production and second, the efficiency with which the factors of production are combined or simply TFP. The latter is largely calculated as a residual that is left over after accounting for the contribution of other inputs.
We find it useful to dwell a little more on TFP. A more precise definition might just help readers. TFP is the ability to combine the factors (labour and capital) more effectively over time and can be interpreted as growth through technological innovation and efficiency achieved by enhanced labour skills and capital management. One could argue that the discourse on India's growth potential puts excessive emphasis on the utilisation rate of capital (the incremental capital-output ratio or ICOR) and does not pay adequate attention to TFP. We try to address this by establishing a simple but robust relationship between TFP growth and the ICOR.
But before bogging the reader down completely in this technical mumbo-jumbo, let's get to the bottom line. The estimates for potential output growth (using two alternative techniques) are somewhat dismal and the estimate barely crosses six per cent. Equally important is the fact that declining TFP is a major factor in this decline from over eight per cent in the mid-2000s.
To figure this out we used two approaches. First, we passed a fine time-varying trend or filter through the data. The second was to use a production function incorporating the key inputs, labour and capital, and measuring both their growth rates and their productivity. The results are dismal. One of the reasons for the low PO and low rates of growth appears to be a sharp decline in TFP. This is not surprising. Simply eyeballing the data reveals that episodes of both high actual and potential growth (the mid-2000s) for instance were accompanied by a surge in TFP growth and declines in headline growth rates were marked by TFP declines.
Thus it is useful to think of India's recovery 'challenge' in the following way. First, the economy has to climb up from sub-potential output to its PO growth of around 6 per cent. It is unlikely that in the near term that in this phase TFP growth will change much; in fact it could even decline.
Thus growth will have to be driven by an increase in the quantum of the factors of production. The low employment elasticity of output (0.2 for 2010-11) suggests that production has become significantly capital-intensive and thus the key to short term recovery lies in growth in investment. The right kind of investment could also remove supply bottlenecks and shore up the non-inflationary investment potential.
There is a commonly held view among economists that investment, particularly in industrial equipment itself raises TFP. Thus we were surprised not to find any significant relationship between the two in the Indian case. If equipment investment alone doesn't do the trick, the question of what really makes a difference to TFP becomes critical.
The need to ramp TFP up to ensure higher growth rates presents us with an interesting policy choice if we attempt to fathom what really drove up TFP in the mid-2000s. We claim that there was a major shift towards exports in this period and a conscious attempt to embed our manufacturing systems in the global supply chain. The rise in India's share in manufacturing exports from around 0.5 per cent of global manufacturing exports to around 1.5 per cent in 2013 was largely driven by this effort at global integration in the middle of the last decade. We also claim that some of spectacular rise in TFP came on the back of this
This brings us to the 'make in India' versus the 'make for India' debate. While it is true that the tepid global growth will constrain export possibilities in the near term and we will have to look inwards to find markets for our goods, a conscious attempt to become an important supplier in global markets will not only help exports in the long term but is also likely to help push up TFP. Thus 'Make in India' might have collateral benefits that go beyond simply expanding our global market share.
Abheek Barua is a consultant at Icrier, New Delhi; Purva Singh is a research assistant at Icrier. These views are their own