Subir Gokarn: India overheating?

In many respects, the Indian economy now is more efficient than it was even just a decade ago

Economic discussion lends itself easily to automotive metaphors. Terms like "accelerating" or merely "cruising" differentiate between successful and not-so-successful economies. The others are, of course, "slowing down", unable to get themselves into a "higher gear".

Policymakers could be "pumping" liquidity into the economy or, however reluctantly, "applying the brakes".

But, there is one dreaded word for both drivers and economists, something that compels policymakers to do the latter rather than the former: "overheating".

Indian cars were, in the past, very prone to overheating. Childhood memories are full of images of long drives being interrupted by smoke billowing out of the engine and buckets of water being desperately scrounged to cool it down.

Of course, those were times during which the economy could scarcely be accused of doing the same. These days, one can own a car for its entire life without even knowing how to get the bonnet open and water has been displaced by much more sophisticated "coolants".

The economy, however, in its similarly modern and globalised avatar has accelerated to a point where the possibility of inflationary""and other""smoke erupting has become tangible.

We have been through one significant episode of overheating in the last decade. Whether the policy response to this was the right one or not is a question that is still being debated.

After last week's announcement of the GDP numbers for 2004-05, we should at least start thinking about the possibility of a recurrence and the appropriate policy responses.

The table gives some comparisons between the previous episode and the current situation to highlight the similarities""as well as the differences.

During the mid-1990s, the Indian economy saw a growth spurt that culminated in three successive years of GDP growth of over 7 per cent. The year preceding this run wasn't entirely shabby, either; 5.9 per cent is still respectable.

The two most recent years, 2003-04 and 2004-05, look similar in comparison, and there is general optimism about a persistence of the current momentum going into the next year at least.

In short, at the aggregate GDP level, if one is not too finicky about the 7 per cent mark, we are in line to repeat the run of 1994""1997.

However, we all know that agriculture is the main contributor to volatility in GDP growth. Growth comparisons across periods are, therefore, highly sensitive to how agriculture performs in those years. If we take agriculture out of the picture and compare the performance of the industry and service sectors, the symptoms of overheating become more vivid.

In the four-year period 1993""97, the slowest that non-agricultural GDP grew in any year was 6.7 per cent. It exceeded 10 per cent in one year. The period 2002""05 is very similar in nature, even if the upper limit has not yet been reached.

In other words, we have already repeated a three-year run of non-agricultural GDP comparable to the mid 1990s.

In short, in growth terms, the parallels between the mid-1990s and today look pretty strong. The striking contrast between the two periods is in the main "smoke signal"""the rate of inflation.

In the first three years of the 1993""97 run, inflation exceeded 8 per cent, even going up to 12 per cent in one year. In any democratic context, this would be red flag for the government.

The loss of most of the state elections in 1995 would have tilted the weight of opinion in the ruling party towards inflation control, even at the expense of growth.

The impact of this policy response on growth was, of course, reinforced by erratic monsoons and declining exports in the wake of the huge depreciation of the East Asian currencies.

In recent years, the growth spurt has not been accompanied by the same kind of inflationary pressures. In the 2002""04 period, the average annual rate of inflation was at or below 5 per cent.

In 2004-05, the inflation rate over April""January has been 6.7 per cent, but this spurt was overwhelmingly the consequence of global oil and other commodity prices, notably steel.

Cost-push or supply-side inflation of this kind is not associated with the overheating syndrome, which is based on demand-pull inflation. It would be reasonable to argue, then, that this period has far greater resemblance with the performance of the newer generation of cars than the older one.

In automobiles as well as in economies, the ability to move faster without increasing the risk of overheating can be attributed to better technology and greater efficiency.

In many respects, the Indian economy of the early 2000s is much more efficient than it was even just a decade ago.

Increased domestic and foreign competition and enhanced productivity have reinforced each other in a virtuous circle that has clearly weakened the trade-off between growth and inflation.

However, as commendable as this achievement is, no one can deny that the signs of the economy hitting various capacity bottlenecks are everywhere and unmistakable.

The faster we grow, the more quickly these bottlenecks will bring the whole process to a grinding halt. Many people would argue that 8 per cent growth in non-agricultural GDP looks somewhat pedestrian in comparison to China, where this indicator is persistently in the double digits.

But, then, the comparison between the older and newer generations of cars becomes relevant. In the old ones, you started to look out for smoke once you crossed the 70 or 80 km/h mark. In the new ones, you can floor the pedal without any such fear.

I suspect that most people would find the former to be a more appropriate metaphor for the Indian economy than the latter.

The last time around, we did not test the power of these constraints, because a combination of demand compression and external shocks slowed us down to a point where they were not absolutely binding.

This time, the rationale for demand compression simply does not exist. The inflationary process that monetary policy can actually influence is dormant.

The appropriate policy response should, therefore, be driven by the need to ease the impending constraints as quickly as possible.

Therein lies the difficulty. It is easier to slow down an economy than to speed it up from already fast rates of growth. If supply constraints are not eased, sooner rather than later, more widespread inflationary pressures will force the policymakers' hands into shifting down into a lower gear and a slower growth rate.

The contrast between the growth-inflation tradeoff in the mid-1990s and now demonstrates just how much more macroeconomic space has been created to speed up growth without overheating. It would be a real pity if this space were not taken full advantage of.

(The author is chief economist, Crisil. The views here are personal).