Faster growth with bigger deficit & higher inflation : India's new growth paradigm

By: TT Ram Mohan
Professor, IIM-Ahmedabad
Article Published in Economic Times.


In 2011-12, a broad consensus on India's growth prospects broke down. The Economic Survey expects growth to accelerate to 7.6% in 2012-13 and 8.6% in 2013-14. Many analysts and investors are sceptical. Which is right? The official view or that of the sceptics?

To begin with, we need to understand what has caused the sharp deceleration in growth in 2011-12 in the first place. Several businessmen and commentators insist that it is internal factors, mainly 'policy paralysis', that have dealt a blow to growth prospects. It is more plausible, however, that the deterioration in the external environment caused by the eurozone crisis is primarily responsible. The survey subscribes to this view.

In 2004-08, the Indian economy grew at 9% on the back of a global boom. Growth slumped to 6.7% in 2008-09 due to the global bust. In 2011-12, the world seemed to be on the brink of a crisis similar to what we had in 2008. One should not be surprised India's growth should of the same order as in 2008. The survey points out that in all the G20 countries except Australia, there was a monotonic decline in growth over successive quarters. India cannot be an exception.

It follows that any improvement in the global environment should translate into a higher growth rate for the Indian economy in 2012-13. There are indeed signs of such an improvement. The IMF chief, Christian Lagarde, said recently that the "world economy has stepped back from the brink and we have cause to be more optimistic".

The sceptics disagree. They argue that even if the global environment becomes more benign, inadequate fiscal consolidation is a fundamental obstacle to India getting back to a high-growth trajectory. This proposition deserves close scrutiny.

It is clear that fiscal consolidation will happen more slowly than thought earlier. The Budget's Medium-Term Fiscal Policy Framework envisages a fiscal deficit-to-GDP ratio of 3.9% by 2014-15. The Thirteenth Finance Commission (TFC) had wanted the ratio to come down to 3%, the target set by the FRBM Act.

A high fiscal deficit is bad for several reasons. One, it creates problems of debt sustainability. This is not an issue for us today. The TFC's target for the Centre's debt-to- GDP ratio of 45% by 2014-15 is expected to be met in 2012-13 itself. Secondly, high fiscal deficits can fuel inflation that dampens investor sentiment. Since fiscal consolidation will not happen as planned earlier, we should expect inflation to remain above the Reserve Bank of India's (RBI) comfort zone of 5%.

It needs to be grasped that a high rate of inflation per se is not a problem. It is variability in the rate of inflation that is the problem as economic agents are then faced with uncertainty. The worry when inflation rate touches double digits is that policymakers have lost control over it, so it can shoot up even further. However, if the RBI can demonstrate that it can contain inflation at 6-7%, growth need not be derailed.

The biggest concern about the slow pace of fiscal consolidation is that it will erode the savings rate and, hence, the rate of investment. High investment rates have been a crucial factor in India's growth rate rising to 9% in 2004-08.

Here is a striking fact: in the period following 2008, the investment rate has averaged 35% despite declines in the savings rate. This is because a wider savings-investment gap has been bridged by foreign flows and shows up as a higher current account deficit. Whereas the current account deficit was 0.4-1.3% of GDP in 2005-08, it rose to 2.8% in 2009-10 and 2010-11.

Now, there is broad agreement that a CAD of 2.5-3% of GDP is manageable for India. Taking the lower end of the range, it would mean that the economy can tolerate a CAD that is 1.2-2.1% higher than in 2005-08. A decline in the domestic savings rate of this order, caused by a higher fiscal deficit, can be made good through foreign inflows.

Adding 1.2-2.1% to the average fiscal deficit of 3.4% in 2005-08, we arrive at a tolerable fiscal deficit level of 4.6-5.5% of GDP. At this level of deficit, the domestic savings rate plus foreign flows can support an investment rate of 35%, which is good enough to deliver growth of around 8-9%. This computation is somewhat conservative. The domestic savings rate, while eroded by the fiscal deficit, could rise on other accounts,such as greater financialinclusion, a decline in the inflation rate and a rise incorporate savings as the growth rate rises.

In short, the slow pace of fiscal consolidation, which appears inevitable, need not come in the way of an acceleration in the growth rate. What it will do is defer India's getting back to the 9% growth path by two to three years.


Since India's integration with the world economy has grown, many wonder whether a high investment rate by itself can deliver a high growth rate when global growth will be sluggish.

Yes it can, because slow growth in the advanced economies is not a big threat as the EU and the North America now account for less than a third of India's exports. It is the disruption of financial flows caused by afull-blown crisis that poses a threat, not slow global growth. If there is such a crisis, all bets are off.

This may sound wildly optimistic but it is possible that India is moving towards a new growth paradigm. The fiscal deficit will remain at a higher level on the average than in 2004-08. Inflation will be above the comfort zone of 4-5%. We will not have a global boom along the lines we saw earlier. And yet, growth of the order of 8-9% will be achievable thanks to a high investment rate.