Mahoshada

At the Indian Economic Summit held as part of the World Economic Forum in New Delhi this past week, the Prime Minister Manmohan Singh said: “India’s economy is growing at an unprecedented rate and we should be targeting a 10 percent growth rate in 2 to 3 years time, which is quite feasible. … The Indian economy has become more open, more globally competitive, yet we continue to have the skeptics, the worriers and the critics. Some have genuine concerns about change; others continue to be prisoners of the past.”

The Prime Minister’s comments came in the wake of the announcement by the Indian government that GDP growth during the first half of the fiscal year was 8 percent. This was a significantly better than expected performance and some economists believe that as a result India will be able to reach an 8 percent growth rate for the entire year.

This naturally leads us to the question, If India can achieve a 10 percent growth rate, why can’t Sri Lanka?

This question is somewhat pointed given the fact that in the past Sri Lanka’s economy has consistently outperformed India’s. For a number of years this country’s economy was more open and generally grew faster than India’s. The average income per person is still about 30 percent higher here – US$ 4,016 when measured in terms of purchasing power as compared with India’s US$ 3,072. But things have been changing. India has remained more committed and more consistent in implementing genuine economic reforms, despite their change in government last year. By some measures, India’s economy is already more open than Sri Lanka’s. Not surprisingly the result has been more rapid economic growth. And if today’s growth rates continue, within about a decade India’s per capita income will exceed Sri Lanka’s.

Requirements for Growth
When an economy grows it does so by producing more goods and services – either by producing goods and services of greater value, or in greater volumes, or, typically, some combination of the two. There are two forces which determine how fast an economy grows. The first is the growth in the supplies available of the resources needed to produce goods and services – what economists term “factors of production” – labour, land and capital. For example, if there were a sudden inward migration of people so that there is more labour available, the economy could grow faster if they went to work. Similarly, if there were an increase in capital investment, growth would be expected to increase. (It is usually the case that the amount of land available remains more or less fixed.)

The second force sustaining economic growth is increased productivity. This happens when the available factors of production are utilized more efficiently, so that more goods and services can be produced with the same labour, capital and land; or there is a shift to produce different and more valuable goods and services. Increasing productivity can entail adopting new technologies, improving management or moving from activities where productivity is low to activities where it is higher.

India’s Capacity for Increased Growth
Prime Minister Manmohan Singh’s statement that a 10 percent growth rate is “quite feasible” is simply not a politician making unfounded promises. It is actually based, at least in part, on sound analysis done several years ago by a one of the world’s best business research groups, the McKinsey Global Institute. In a detailed published report they wrote that “with the right new policies, GDP growth of 10 percent a year is within India’s reach.” (This report is freely available on the internet at www.mckinsey.com/mgi/).

They went on to say, “there are three main barriers to faster growth: the multiplicity of regulations governing product markets (i.e., regulations that affect either the price or output of a sector); distortions in the land markets; and widespread government ownership of businesses. We estimated that together, these inhibit GDP growth by around 4 percent a year. In contrast, we found that the factors more generally believed to retard growth – inflexible labour laws and poor transport infrastructure – while important, constrain India’s economic performance by less than 0.5 percent of GDP a year.”

It is, however, worth noting that some argue that India’s infrastructure constraints represent a greater impediment to growth than suggested in the McKinsey report. The president and CEO of General Electric in India, Mr Scott Bayman, said this week that “If India ‘dropped in China’s infrastructure’, it could achieve 10 to 12 percent growth.” But both viewpoints are consistent in suggesting that India can expect to maintain much higher growth rates if the government continues to make progress with the reform process.

Sri Lanka’s Capacity for Increased Growth
Last week in this newspaper there were two articles addressing the question, Is it a reasonable prospect for Sri Lanka to achieve a 10 percent growth rate? One was by Mr T. L. Gunaruwan, Senior Lecturer (Economics) at the University of Colombo while the other was by Mr S. A. Karunaratne, former Director General of the National Planning Department. These followed an earlier article by Mr Gunaruwan with a rejoinder by this writer.

Both of these other writers adopted a somewhat more restrained view on the prospects of Sri Lanka reaching a 10 percent rate of growth. While both agreed that steps to improve productivity could lead to higher rates of growth, they also put much more weight on estimates of the additional capital investment that would be required, based on the past relationship between investment and GDP growth, (i.e., the so-called incremental capital output ratio, or ICOR). For example, Mr Karunaratne summed up his view by saying, “My firm belief is that even after a very optimistic adjustment, the 10 percent planned growth rate may indicate a massive rise in investment which is not at all practical in the present circumstances.”

But if one compares levels of investment in capital, India and Sri Lanka were virtually the same in 2004: gross fixed investment in India was 23.8 percent of GDP last year, just slightly more than the 22.4 percent of GDP here. In contrast, Bangladesh was at 23.5 percent while Malaysia was at 21.7 percent. Malaysia and India grew at substantially higher rates than Sri Lanka while Bangladesh was somewhat lower.

Looking beyond simple comparisons, more in-depth analysis has also found very little relationship between investment in capital and output. Indeed, one study that included 138 countries found the expected relationship in only 11, (a 1997 World Bank study by William Easterly). None of this should be surprising because as was pointed out earlier, investment is only one ingredient in the recipe for economic growth. One has to pay attention to all of the factors at work.

The McKinsey India report directly addressed this very same point. “Many policy makers and commentators believe it would take investment equivalent to more than 35 percent of GDP, an almost unattainable amount, to achieve a 10 percent GDP growth rate in India. Our analyses however suggest that at the higher levels of labour and capital productivity, India can achieve rate of GDP growth with investment equivalent to only 30 percent of GDP a year for a decade, less than China invested between 1988 and 1998. Although still a challenge, this rate is certainly achievable, since removing the barriers that hinder productivity will unleash extra funds for investment, equivalent to the consequent drop in the public deficit and increase in FDI [Foreign Direct Investment]. These sources, by themselves, would be sufficient to increase investment from its current [2001] level of 24.5 percent of GDP to 30.2 percent.”

In fact, the McKinsey report may have been too pessimistic. Since this was written, it turns out that India has been able to substantially increase her growth rate even though capital investment relative to GDP has remained more or less constant in recent years.

All of this strongly suggests that improving overall productivity plays a much greater role in determining economic growth than many had previously thought. Indeed, during the last fifty years in economics, there has been a steadily increasing emphasis given the role of improving productivity, and the policies and institutions that determine productivity, in the assessment of the factors responsible for economic growth.

Can Sri Lanka Keep Pace with India?
If India looks set to achieve a 10 percent growth rate within the next several years, one should ask why Sri Lanka could not also do so. The answer is, of course, that this country could meet or surpass India’s economic performance. It has done so in the past and there is no inherent reason why it could not do so again.

The steps needed to do this are well known. Sri Lanka currently has substantial shares of resources either unemployed or employed in activities with low productivity. For example, with a labour force of about 8 million, nearly 700,000 are unemployed and one million employed in the public sector – where it is well known that productivity is very low. In addition, there are about one million working overseas, contributing to economic growth in other countries.

The government owns more than 80 percent of the land in the country. Due to the lack of well functioning markets, land is generally not being allocated in the most productive ways. As a result, large amounts of land are either not being used at all or are being used in ways that contribute little or nothing to the national economy.

Finally, by running very high budget deficits and using workers’ savings through the provident funds to finance these deficits, resources that could be used to increase capital investment are being used to pay for current government consumption. It would not be nearly so bad if these deficits were being incurred as a result of public investment in infrastructure, but they are not. In addition, very substantial amounts of capital are being inefficiently employed in many of the large state owned enterprises.

If it were possible, say over the next decade, to shift substantial proportions of these resources into more productive employment, and to increase the efficiency of those that remained employed in the public sector, there would be an enormous boost to the country’s growth rate and average incomes. Such a process could also be expected to make Sri Lanka a much more attractive location for investment, reinforcing the positive impact on growth.

Mr Gunaruwan and Mr Karunaratne both made the point that making these sorts of changes would not be easy. That is certainly true. If it were easy, there would be far fewer developing countries struggling to reduce poverty and improve economic welfare among their people. But the fact that a number of countries have been successful, and the evidence that India is moving in this same direction, makes clear that although difficult, the task is not impossible.