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Goldman Sachs Report on India
Introduction : BRICs and Beyond
It is now six years since we coined the term 'BRIC' in our Global Economics Paper, 'Building Better Global Economic BRICs', published on November 30, 2001. Since then, these countries' equity markets have seen a remarkable increase in their value: Brazil has risen by 369%, India by 499%, Russia by 630% and China by 201%, using the A-share market or by a stunning 817% based on the HSCEI.

The equity market performance is just one manifestation of the staggering rise in BRICs' importance to the global economy. In our 2001 paper, we argued that the BRIC economies would make up more than 10% of world GDP by the end of this decade. In fact, as we near the end of 2007, their combined weight is already 15% of the global economy. China is poised to overtake Germany this year to become the third-largest economy in the world. Our 'BRICs dream' that these countries together could overtake the combined GDP of the G7 by 2035 - first articulated in our 2003 Global Economics Paper 'Dreaming with BRICs: The Path to
2050' - remains a worthy 'dream'.
India's Rising Growth Potential - India's Scope for Catch-Up
On the eve of the Industrial Revolution (around 1770), India was the second-largest economy in the world, contributing more than 20% of total world output. By the 1970s, after two centuries of relative economic stagnation, that share had fallen to 3% the lowest in its recorded history. From a long-term perspective, the post-industrial economic decline of India (and China) is a historical aberration, driven to some extent by a lack of openness. After independence in 1947, India followed inward-looking and state-interventionist policies that shackled the economy through regulations, and severely restricted trade and economic freedom. The result was decades of low growth, pejoratively termed the 'Hindu rate of growth'. Reforms beginning in 1991 gradually removed obstacles to economic freedom, and India has begun to play catch-up, steadily re-integrating into the global economy.
Productivity Accelerates
India's growth performance since independence in 1947 has been well below potential, stymied by low productivity. From 1960 to 2000, annual total factor productivity (TFP) growth averaged a mere 0.25%. Tentative steps to reform the economy in 1985, and then fundamental reforms since 1991, moved the economy up a gear, with growth averaging 6% and TFP growth moving up to an average of 1.6% per year.

To estimate the productive capacity of India’s economy and understand its sources of growth, we used a supply-side approach, distinguishing between contributions of TFP and of inputs of capital, labour and human capital, to obtain the underlying ‘potential’ or trend growth rate. We first stripped out all cyclical variations in inputs to calculate the trend. We then cyclically adjusted productivity growth to obtain the trend. By measuring the ‘potential’, we seek to estimate the rate at which the economy can grow without ‘overheating’ or igniting inflation. This rate is useful as it provides a benchmark against which to assess actual growth outcomes.

Since 2003, there has been a structural increase in India’s potential growth to nearly 8% from 5%-6% in the previous two decades. Productivity growth has been the key driver behind the jump in GDP growth, contributing nearly half of overall growth since 2003, compared with a contribution of roughly one-quarter in the 1980s and 1990s.
Baseline Projections
Based on our supply-side framework, we projected potential growth rates for India till 2020. The chart below shows our projections for the overall growth rate and contributions from productivity, capital, labour and education. Keeping current rates of savings and investment roughly constant, we project India's potential growth rate at an average of 8.4% till 2020, on the back of continued productivity growth, favourable demographic factors and further growth in educational attainment.

Our baseline scenario is derived from fairly conservative assumptions:

  • The investment/GDP ratio is assumed to remain roughly constant at around 29% of GDP (in real terms).
  • The growth rate in average years of schooling is assumed to decline gradually in line with trend. This means an increase in average years of schooling from 5.8 in 2006 to 7.3 by 2020.
  • For the labour input, according to demographic trends, over 100mn people will enter the labour force by 2020. We assume no increases in labour force participation rates and that the rate of unemployment stays at its natural rate (4.4%, the average unemployment rate from 1977-2005). If participation rates were to increase by a quarter of a percent each year from the current rates of 61%, this would add another 25mn to the labour force in the next 10 years.
  • For TFP growth, we assume an average annual rate of 3.3%. We think this is a reasonable assumption based on the large scope for catch-up, the continued movement of labour and land from agriculture to other sectors, aided by continued openness to trade, financial deepening, investments in information and communication technology, and the building of highways. These are discussed at length below.

Why Productivity Growth Is Likely to Be Sustained
The proximate cause of the increase in productivity since 2003 is the increased efficiency of private-sector firms in the face of growing competition. The gradual liberalisation of the economy introduced a competitive dynamic that forced the private sector to restructure during the relative slowdown in growth and corporate profitability during 1997-2002. After the restructuring, the private sector emerged leaner, fitter and more productive. The presence of constraints, including the lack of adequate infrastructure and a set of demanding, value conscious consumers, forced companies to innovate on products, processes and distribution, which, in turn, created companies that are more efficient and competitive.

In our view, the underlying causes for the increase in efficiency of private firms have been trend acceleration in international trade, financial deepening and investments in and adoption of information and communication technology. The process that tentatively began after the onset of reforms in 1991 is also the cumulative effect of a decade of liberalisation, a vital component of which was the gradual deregulation and de-licensing of industry.

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