India's Domestic Demand is Highest in the EM Space

June 23, 2016Indiaby East Asia Forum

India has the greatest domestic demand of all EM countries.

According to current IMF projections, India is now the fastest growing major economy in the world. In 2016, it is expected to grow over a full percentage point faster than China. This is a remarkable turnaround by any standard and especially impressive against the backdrop of a stagnant global economy.

In the second quarter of 2011, the Indian economy appeared to be in a downward spiral of almost 12 successive quarters of falling growth, including several quarters of below 5 percent growth. Then, within the space of just a year, there was a change in government, a change in the base year for indexing prices, in data coverage and in the methodology for measuring growth. The revised GDP estimates showed an economy growing above 6 percent since 2012–13 and topping 7 percent since 2014–15.

There was understandable skepticism, including within the central bank, regarding the reliability of the new growth estimates. They seemed out of sync with several other data measures, such as the index of industrial production, export growth, savings, investment and credit growth, which all remained depressed.

Although some questions remain unresolved, there is now a better appreciation of some of the quirks of these growth measures. First, India is a commodity importer. This means that, all other things being equal, a sharp decline in commodity prices, and especially in oil prices, boosts GDP by increasing domestic value added.

While exports declined during this period, imports declined even more steeply. Overall, this meant a decline in India’s current account deficit from over 6 percent to just under 2 percent of GDP. This, in turn, boosted national income. India’s central bank governor feels that the overestimation, if any, should not exceed 1 percent. This would mean that India is still growing as fast as China.

There are good reasons why India could be the new engine of growth for which the flagging global economy is searching. Conference Board data shows that while other countries’ labour productivity growth is flagging, India’s is on the rise. This is the result of India’s growing and young labour force, and the large numbers exiting low productivity jobs in agriculture.

At around 70 percent of GDP, India’s domestic demand is the highest of all major emerging market economies. This may not be as high as advanced economies — which sit at around 75–80 percent — but it is far higher than China’s 50 percent, and the 65 percent average for developing countries.

This is hugely significant in a global economy where the major final export destinations are all advanced economies that are currently experiencing negligible growth. China is currently attempting to change its growth model to avoid such traps of export-led growth, but this is not easy to do.

Therefore, what are the prospects of India sustaining, or even exceeding, its current 7–7.5 percent growth? Due to its fast growing middle class, India is a domestically driven economy. Thus, it remains a supply, rather than demand, constrained economy — a sweet oddity in the current global environment. In addition, India’s current commodity cycle is expected to boost the disposable income of its middle class which, when combined with the imminent pay rise for public servants, will likely further enhance consumption.

In a demand constrained, albeit open, global economy, domestic supply-side pressures are unlikely to act as a constraint on growth. For India, the real pressures on growth come from macro-economic imbalances, such as high fiscal and current account deficits, inflationary pressures and the overall policy environment.

India has thus far been lucky, as the sharp downswing in the global commodity cycle has moderated India’s twin deficits and inflationary pressures. India’s economy has also been aided by a prudential central bank focused more on targeting inflation than on raising growth at any cost. In addition, its huge stocks of foreign exchange reserves insulate it from external shocks, including the unlikely event of a rise in global interest rates.

However, the global economic environment is not favourable for enhancing current growth rates. Growth at 7 percent is arguably the ‘new normal’ for the global economy. And, since India’s engine of growth is primarily domestic, the success of the growth enhancing ‘Make in India’ and ‘Start Up India’ initiatives hinge not so much on external demand as on creating a globally competitive investment-enabling environment.

Quickly bridging India’s putative infrastructure deficit (both physical and social), fixing the rigidity in land and labour markets, ridding corporate and bank balance sheets of past excesses, and reforming tax administration will be critical in this regard.

A reasonable start has been made on all these fronts under the new government. As a result, India overtook China to become the top destination for foreign direct investment in 2016. However, going forward, these commitments will need to be translated into actual investment on the ground.

Although India has been able to sustain its higher growth trajectory since the 1990s, recent history shows that time and again it has missed the bus in realising its true potential. Effectively managing the bitter and adversarial polity, as well as fringe elements within the ruling party itself, is key to maintaining the current momentum.

Demystifying Indian growth is republished with permission from East Asia Forum