A five-year baseline scenario

This column first appeared in Business Standard, on October 20, 2014.  Like other products of the Brookings Institution India Center, this is intended to contribute to discussion and stimulate debate on important issues. The views are those of the author.

At the annual meetings of the World Bank and the International Monetary Fund (IMF) earlier this month, headlines were grabbed by the rather pessimistic outlook for the global economy in the near future. This was the basis for a strong recommendation that economies in the region most at risk, Europe, should consider reversing the rather severe fiscal contraction that they have been pursuing over the past few years and increase public expenditure, particular on infrastructure. This is an issue that I’ve explored in a number of previous columns, so in this one, I want to go behind the headline issues and look into some numbers that the IMF’s World Economic Outlook (WEO) presents on the Indian economy.

The WEO makes five-year projections of key macroeconomic indicators for over 180 countries. In an interlinked global model of this kind, each country’s specific conditions and context are clearly somewhat in the background. The exercise is most useful as a baseline, business-as-usual projection, assuming no dramatic game-changing developments, either positive or negative. The WEO’s five-year scenario for India is the subject of this article.

First, looking at the growth trajectory (the IMF forecasts gross domestic product, or GDP, at market prices for the calendar year), growth in 2014 is expected to accelerate a bit from the five per cent clocked in 2013 to 5.6 per cent. 2015 will see a further acceleration to 6.4 per cent, but after that, growth plateaus out in the 6.5-6.7 per cent range until 2019. In effect, the projection says that while the Indian economy will see a recovery over the next five years, the upside is somewhat limited.

Second, the consumer price inflation projections provide some comfort, but not a whole lot. After highs of 10.2 per cent in 2012 and 9.5 per cent in 2013, there is a steady decline. The projection for 2014 is 7.8 per cent. It declines from 7.4 per cent in 2015 to six per cent in 2019. This pattern suggests that the growth recovery will not be strong enough to trigger significant demand-side pressures, which would push the inflation numbers up again. It also implies that the room for monetary stimulus remains quite limited over this horizon.

Third, the projections for the investment-GDP ratio indicate that this very important driver of growth will stabilise at a reasonable level. It declined sharply from 34.8 per cent in 2012 to 31.4 per cent in 2013. However, with a slight recovery to 32.2 per cent in 2014, it continues to climb to 33.1 per cent in 2017 and remains at that level until 2019. It certainly is reassuring that investment remains in a range that should be able to support growth in the six-seven per cent range.

However, the devil is in the composition. Going by the experience of the past few years, the same investment ratio can co-exist with a wide range of growth outcomes. To maximise the productivity of investment, it has to be balanced across critical sectors so that no bottleneck emerges. The message from the annual meetings is something that Indian policymakers need to take to heart; they have to find ways to put large amounts of money into infrastructure and, in the current context, I do not believe that there is a viable alternative to public spending on this.

Fourth, the projections for net government borrowing as a percentage of GDP (not quite the same as the fiscal deficit as we define it) also suggest that fiscal consolidation is an achievable objective. This variable was estimated to be 3.1 per cent in 2012 and 2.6 per cent in 2013. It is expected to remain at that level in 2014 and decline steadily to 2.1 per cent by 2019. There are a number of positive implications of this.

From a foreign-investment perspective, this baseline removes the risk of a sovereign rating downgrade from the equation. Domestically, declining government borrowing is tantamount to monetary easing, as it softens the longer end of the yield curve, which will support the growth recovery. But the caveat about the composition of public expenditure is valid here as well. We need fiscal consolidation, but we also need more spending on infrastructure,which means the “how” of consolidation is as important as the “how much”.

Finally, the current-account deficit as a ratio to GDP strongly reinforces the overall picture of macroeconomic stability that emerges from the baseline. From the high of 4.7 per cent seen in 2012, it dropped sharply to 1.7 per cent in 2013. It is expected to increase somewhat over the next five years, but move within the range of 2.1 to 2.6 per cent, something that should create no significant vulnerability to external shocks. In this range, capital inflows should easily cover the deficit and the rupee should remain quite stable.

I draw three implications from this baseline scenario. First, notwithstanding the IMF’s rather negative view of global prospects, India is seen to be entering a phase of relative stability, with all the indicators showing an improvement compared to the past couple of years. More importantly, these improvements are not expected to be short-lived. These projections broadly reflect both the space that the government has to achieve a reasonable set of macroeconomic outcomes and its ability to use that space effectively.

Second, it must be emphasised that the macroeconomic stability that is being projected does not match aspirations of economic performance. Stability can, of course, be consistent with a range of outcomes; the growth and inflation outcomes in this baseline scenario are not particularly attractive. Growth between six and seven per cent over a five-year period will leave the country far short of meeting legitimate employment and quality of life aspirations. Structural, game-changing reforms are critical; what the projections suggest is that there is a significant buffer being provided by the macroeconomic situation for a government that takes on the challenge.

Finally, recent developments in the global oil market may actually significantly improve outcomes relative to this baseline. If the current price situation persists – and I think there are good reasons to expect that it will – within the same fiscal-monetary configuration, all these indicators will look a lot better. There will be even more space available and less risk for structural reforms.