Sunday, March 9, 2008

Aggregate Demand growth trends in India

The Economic Survey 2007-08 claims that the economic growth has slowed down from 9.6% in 2006-07 to 8.7% for this year, and feels that it may be difficult to sustain a 9% GDP growth rate. It however explains that the investment climate is full of optimism. The slowdown has raised questions about whether we can sustain the growth in our aggregate demand (AD), especially in light of strong headwinds like US recession, appreciating rupee, infrastructure bottlenecks, inflationary pressures arising from rising oil and commodity prices etc. This post will analyze the long term savings, investment and consumption trends, and argue that our concerns about AD may be misplaced for a number of reasons.

Eco 101 teaches us that AD is a function of Consumption (C), Private Investments (I), Government Spending (G) and net Exports (X-IM). All this in turn depends on three important economic expectations - wealth, interest rate and exchange rate effects.

Wealth effect refers to the impact of a change in the aggregate price level on the purchasing power of consumers' assets. A lower price level raises the real value of households' assets, which stimulates consumption and thereby investment. Interest rate effect is the effect of a change in the aggregate price level on the purchasing power of consumers and firms' money holdings. A lower price level reduces the amount of money demanded, keeping interest rates low, thereby boosting investment and consumption. Exchange rate effect is the impact of a change in the aggregate price level on the net exports. A lower aggregate price level causes depreciation in the real exchange rate, thereby boosting net exports. A lower price level therefore shifts the AD curve to the right.

The downward sloping AD curve shifts due to the following changes
1. Changes in expectations of firms and individuals about the future, which pushes up or down consumption and investment spending.
2. A change in the "wealth effect" arising due to the formation or popping of an asset bubble or some external event, which causes a change in consumption spending. Asset bubbles increase AD by boosting consumption.
3. Changes in the stock of physical capital through investment spending, by either private sector or government.
4. An external event that puts pressure on the local currency, either forcing it up or down, thereby affecting the net exports.

As the Economic Survey and many other independent surveys of both firms and consumers have shown, the investment and consumption climate remains robust. This is understandable given the strong economic fundamentals. Unlike in the US, asset bubbles have not been a part of our economic landscape. Even the equity market boom appears to be more a part of a cyclical movement, and in any case is not broad-based (just 7% of population invest in equities or debt) enough to affect the larger economy. The huge infrastructure and other spending, both by the Government and the private sector, will ensure that the stock of physical capital is bound to increase sharply in the short and medium term. While the rising rupee and oil will put pressure on the external front, it is not likely to have any major impact given the small contribution of the external sector to economic growth.

The Economic Survey 2007-08 acknowledges that the most important contribution to economic growth has come from investment and consumption, with the external sector having a small negative effect. The average rate of growth of Gross Domestic Capital Formation (GDCF) during the Tenth Five Year Plan has more than tripled to 17.3 per cent per year from an average growth of 5.3 per cent per annum in the Ninth Five Year Plan, and its contribution to the GDP growth, tripled from 19.4% to 65.4% during the same period.

The GDCF has been growing steadily from 22.8% of GDP in 2001-02, 35.5% in 2005-06, 35.9% in 2006-07, and is estimated to be 38% in 2007-08. The private sector share of this investment has been growing from 16.7% of GDP in 2001-02 to 25.8% and 27% for 2005-06 and 2006-07, respectively. The share of public sector is stabilizing at about 8% of GDP. The trends in savings and capital formation appears to have been clearly established and are encouraging. Further, gross fixed capital formation (GFCF) is estimated to grow by 15.7% in 2007-08, compared to 14.3% for the tenth plan period and 15.1% for 2006-07. Its contribution to the GDP growth is expected to rise to 55.2% in 2007-08, from 45.5% the previous year.

The net savings have been growing robustly, rising from just 23.5% of GDP in 2001-02 to 34.8% in 2006-07. Buoyed by expanding bottomlines, the private sector has contributed handsomely by increasing their savings to 7.8% of GDP in 2006-07 from just 3.4% in 2001-02. While private sector savings appear to be stabilizing around 24% of GDP, the most heartening development has been the significant improvement in public sector savings, which rose from -2% in 2001-02 to 3.2% in 2006-07, and is rising fast. This, coupled with the reduction in fiscal deficit, will ensure a "crowding in" effect for private investments.

The biggest contribution to our spectacular economic growth this decade has come from private consumption. A rapidly expanding, aspirational middle class, spurred on by the rising IT and service sector wages, falling taxes and a low interest rate regime that led to an explosion of hire purchase schemes, have ushered in a boom in consumer goods and services. Private consumption formed 43.9% of GDP growth in 2006-07, and is estimated to rise to 45.8% in 2007-08, though the share of government consumption is estimated to slip from 6.5% to 6.2% in the same period. The relative share of government consumption with respect to the GDP has been stable at around 10% while that of private consumption has been around 60%. A higher government spending increases AD. But higher taxes, lowers the disposable income and decreases AD. Here too, while direct spending by the government increases AD directly, transfers like lower taxes influences AD only indirectly (since the consumers can also save the extra money available).

But 2007-08 has seen relatively tighter credit markets and accordingly the growth rate of bank credit for purchasing consumer durables declined from 11.2 per cent (y-o-y November 2006) to 4.4 per cent (y-o-y November 2007). Correspondingly, the growth rate of production of consumer goods declined from 10.2 per cent (April-December 2006) to 5.9 per cent (April-December 2007). This slowdown in consumption growth is estimated to result in a 0.7% decline in GDP growth out of a total decline in GDP of 1% this year. But the slowdown is not likley to be a long term trend. This aforementioned fact highlights the increasing importance of interest rate effect on economic growth.

In real rupee terms, export and import growth has slowed down to 6.4 per cent each during 2007-08 from an average of over 20 per cent growth in exports and over 22 per cent in imports over the last three years. The net exports in goods and services to the real GDP ratio was -4.2% in 2006-07 and is estimated to be around -4.1% in 2007-08. But the share of net exports to GDP growth is estimated to precipitously fall to -3.2% in 2007-08, from -18.2% in 2006-07. This trend is likely to persist in 2008-09 as well, thereby acting as a relatively smaller dampener in the aggregate demand growth. The Economic Survey also refers to the beneficial spillover effects of a trade deficit on productivity and efficiency.

The overall trends adjusted for small cyclical variations, clearly point to a healthy environment for AD. There are also a few other reasons as to why AD is likely to remain robust in the immediate future. All these developments are likely to shift the AD curve to the right and expand aggregate output.
1. The Sixth Pay Commission is likely to pour an additional Rs 350 bn into the hands of employees. Wages, salaries and pensions as is expected to rise from 2.1% of GDP in 2007-08 top 2.6% in 2008-09.
2. The lower effective Income Tax rates, arising from higher threshold levels, changes in slabs, and concessions to women, will put more disposable income in the hands of the middle class. It is precisely these income categories that are most likely to spend, rather than save their additional incomes.
3. The farmers' loan waiver has effectively made the farmers richer by Rs 60,000 Cr, with the possibility of accessing more loans. Since their Marginal Propensity to Consume is very high, all this money is most likely to be consumed rather than saved. The multiplier effect of this on the rural economy will be considerable.
4. The cuts in indirect taxes - CENVAT and excise duties - is expected to generate a "wealth effect" that will spur consumption.
5. Construction sector is likely to expand at a spectacular pace given the massive investments already committed and being proposed in infrastructure and commercial and residential real estate development. The expected reduction of interest rates for smaller house loans will provide a filip to the sector. Construction sector contributed 12.9% to the total GDP growth during the tenth plan period, and this share is expected to increase further, especially given its very low ICOR of 1.2.
6. The prospects for any interest rate hikes, even with slight inflationary pressures, are ever so remote. Even in the exceptional case of rate hikes, they are most likely to be short term measures. The possibility of a leftward shift of the AD curve due to interest rate effect appears remote.

As can be seen, consumption, investment and government spending will remain robust and grow fast. Further, the respective rates are now comparable to what initiated the East Asian economies and China along their high growth trajectory. The wealth effect is likely to be very strong, and interest rate effect significant. Any negative influence of the exchange rate effect is likely to be small and in any case over-ridden by the other effects. In the worst case, the growth in AD could slowdown slightly, thereby slowing down the GDP growth by about a percentage point. Given the supply side constraints - poor infrastructure, lack of adequate skilled technical manpower etc - this slight slowdown may be a positive development in so far as it cools an overheating economy and wards off inflationary pressures.

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