The Indian economy is in a sweet spot

India’s real GDP growth accelerated from 5.7 per cent y-o-y in FY13 to 7.9 per cent last year. The economy hit a road bump in FY17 as growth slowed to 7.2 per cent y-o-y in the first three quarters. Fortunately, this will be temporary. Growth will pick up again to 7.6 per cent this year through an improvement in consumption, timely rains, higher public sector spending, and better export growth. Investment growth will however continue to trail because of ongoing deleveraging in the corporate sector and stressed banks’ balance sheets.

The cyclical upswing will also be lifted by structural tailwinds. This story will be strengthened by two domestic factors (demographic dividends and higher productivity), as well as a favourable external environment.

We have long emphasised that India has one major advantage over G3 and many Asian economies — the growth in its working age population is not peaking. In fact, India’s working age population will exceed overall population growth for at least two more decades. In turn, this will lead to a sustained fall in its dependency ratio. According to the UN, India’s working age population will, between 2015 and 2040, rise from 66 per cent to 68 per cent of its total population. Based on this trajectory, India will overtake China, whose share will fall from 73 per cent to 62 per cent over the same 25-year period. A growing working age population is a necessary but insufficient condition for growth. This demographic dividend needs to be harnessed effectively, through higher labour absorption and job creation. India’s labour force is presently highly fragmented and concentrated in the unorganised sector.

Hence labour issues need to be addressed on three counts: (a) Growth needs to be inclusive and generate sufficient employment; the employment elasticity to growth has been receding in recent years; (b) The workforce needs to be skilled; and (c) A high proportion of casual/informal labour needs to be covered by employment rules and regulations. If tapped effectively, faster growth in India’s working age population will crucially to the overall GDP growth.

Apart from India’s demographic strength, we are also optimistic on productivity prospects. Firstly, India’s incremental capital output ratio (ICOR) has eased to 4.0 in the first three quarters of FY16-17 from 6.3 in FY12-13. We, however, caution against reading too much into this. Part of this decline can be attributed to an easing investment-to-GDP ratio.

Secondly, labour productivity has been softening. Labour productivity per person employed eased from 10 per cent in 2010 to 4.8 per cent in 2016, according to the US Conference Board estimates. Slower productivity and thereby slower output and incomes have kept per capita GDP at depressed levels for a long time.

Part of this dip was attributed to better efficiency brought about by technology and innovation. In India’s case, these changes are just beginning to take root. Hence, there is sufficient headroom for productivity levels to improve and raise growth levels.

These productivity gains are expected to get another shot in the arm from ongoing and upcoming reforms, which are moving in the right direction:

(a) The execution of labour reforms and land acquisition has been pushed to State governments, but changes here are expected to be gradual.

(b) The operating architecture will be tightened by rationalising the number of documentation/clearances, simplifying the legal framework, lowering the number of institutions, etc.

(c) FDI will be encouraged by lifting sectoral caps, beefing up infrastructure capacity and improving the ease of doing business. To improve the rollout of FDI, the Cabinet will phase out the Foreign Investment Promotion Board (FIPB) from April. In return for a strong consumption-driven market, foreign investments will bridge part of the funding gap for infrastructure projects and provide technological know-how to expand the domestic manufacturing base.

(d) Simplifying the taxation structure is the next priority, with the rollout of GST in July 2017 under close watch. The GST system’s long-term benefits include better transparency, higher revenue generation, a wider tax base, collection efficiency, formalisation of the economy and limiting tax evasion/corruption.

(e) Plans to increase use of technology and digitalisation across sectors including banking services, healthcare, education, startups etc.

(f) Expanding the manufacturing base, which will be positive for job creation given its better absorption levels.

(g) Promoting social sector programmes like financial inclusion and direct benefit transfers which will help plug leakages.

(h) Formalising the economy and encouraging the scaling-up of manufacturing activity (smaller unorganised sector).

(i) Addressing corruption/lower tax evasion with closer scrutiny on deposits after the banknote ban, income declaration schemes, passage of amendments to the Benami Property Act, plugging tax loopholes through changes to the double taxation agreements, amongst others.

On a positive note, these changes are taking place at a favourable time in India when inflation is benign (at 5 per cent y-o-y in FY17-18) amidst a narrower current account deficit, rising foreign reserves, credible fiscal consolidation efforts, and bullish domestic markets.

A conducive external environment is also proving to be a bonus. G3 economies are considering rolling back the ‘extraordinary’ monetary stimulus measures adopted in the past 7-8 years. This is a positive sign that they are moving towards a more sustainable recovery.

The Federal Reserve is leading the process to normalise monetary policy, which started with the tapering of asset purchases in 2014, followed by three hikes from December 2015 to March 2017.

We expect three more US rate hikes this year. The European Central Bank, in early March, declared victory against deflation and might consider another reduction in its asset purchase programme in 2H17. The Bank of Japan is also unlikely to consider further accommodative measures. Despite the optimism, the world economy is also facing new challenges such as US-led protectionism, the rise of far-right populism in the Euro Zone, and China’s priority to maintain financial stability and address its debt levels.

We see India’s ongoing cyclical upturn getting a hand from structural tailwinds. The structural story will be supportive of long-term growth prospects, provided the demographic dividend is harnessed effectively and productivity continues to improve on timely reforms.

The writer is an economist and vice-president of DBS Bank, Singapore