Indian Financial Markets

The Economy 21

evidence on the cyclical properties of consumption is not available. However,

we may hazard some conjectures. Consumption smoothing requires financial

depth through possession of liquid wealth such as securities, and it requires

credit access. At present, most households lack both kinds of tools for con-

sumption smoothing. Hence, it is likely that consumption in India is more

sensitive to the business cycle than in countries like the United States and

the UK.

1.3.7 LOOKING FORWARD

From first principles, economic growth comes from changes in labor, capital

and productivity. The discussion above has brought out strengths on all three

fronts:

• Demographics, education and learning-by-doing are generating a process

of improvements in labor.

• Capital is characterized by a rising savings rate, improved access to for-

eign savings, and a market-dominated financial system with information

processing done through speculative markets.

• Finally, improvements in infrastructure, rationalization of the role of the

State in the domestic economy, reducing barriers to trade and height-

ened competition between competent firms are key drivers of productivity

growth.

India is hence in a remarkable situation where there is a positive outlook on

all the three ingredients that go into growth: labor, capital, and productivity

(Kelkar, 2004b). This suggests that the trend GDP growth rate will further

accelerate in the future. However, the present state of knowledge does not permit

numerical estimates of either the date or the magnitude of this acceleration.

1.4 TRENDS AND VOLATILITY IN GDP GROWTH

GDP growth seems to involve growth cycle fluctuations about a long-term trend

GDP growth rate, which, in turn, has been steadily accelerating. In order to

measure this phenomenon, we create a ten-year moving average of GDP growth,

in order to eliminate some of the distracting noise in the growth cycle.

14

Years of negative GDP growth were observed in the past, and were invariably

associated with a drought. The reduction of the share of agriculture in GDP

14

For a business cycle perspective on Indian macroeconomics, see Shah (2008).

22 India’s Financial Markets

1960 1970 1980 1990 2000

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10–year mean growth

10–year volatility

FIGURE 1.8 Ten-Year Moving Average Growth and Its Volatility

has led to a diminished importance of such issues. Fluctuations away from the

trend were largely driven by agriculture in the earlier years; in recent decades

the drivers have been modern phenomena like investment and inventory

fluctuations of firms.

In understanding the evolution of GDP, it is particularly interesting to look

at the ten-year moving average and standard deviation of annual GDP growth,

to get at the underlying long-term trends (see Figure 1.8). This evidence high-

lights two main facts. First, from roughly 1979 onward, the trend in GDP

growth has accelerated from 3.5%. Second, the volatility of GDP growth has

dropped sharply. In 1980, India was a low-mean, high-variance macroeconomy.

Over the years, it has increasingly become a high-mean, moderate-variance

macroeconomy.

The most recent values suggest that the mean or trend GDP growth is around

6.2% with a cycle around it which has a standard deviation of roughly 1.9

percentage points. It appears fair to think that under “normal business cycle

fluctuations,” GDP growth will not drop below 4.5%. Growth below 4.5% would

require a currency crisis or a political crisis. This reasoning suggests that while

the economy will be growing at good rates, this will not be growth at a steady,

unvarying rate. The economy will definitely witness cycles in growth rate. Busi-

ness cycles in the Western sense of the term are unlikely to be found since the

probability of negative GDP growth is negligible. The growth cycle is affected

by both local factors and the global business cycle.