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Mapping The Trend Rate

A quicker-than-expected recovery for the economy does not have to encompass a huge reforms initiative

Economies undergo successive cycles of expansion and contraction as supply tries to match demand. Once a cyclical expansion hits the supply limit, inflation occurs until demand eases and there’s a contraction.

An average growth rate is maintained through the expansion-contraction cycle – this is often referred to as the trend rate. The trend rate of growth can be boosted through structural changes that increase economic capacity.

India saw such a set of structural changes in the early 1990s when various artificial controls and licensing constraints were removed. It occurred again in the early 2000s, when the first drive to improve infrastructure was launched.

The policy liberalisations of 1991-93 improved the trend rate by about 1-2 per cent of GDP. The infrastructure creation of the early 2000s may have helped improve the trend rate by another 150-200 per cent. As a result, the Indian economy, which grew at 2.5 per cent in the 1970s, is now growing at a trend rate of around 7 per cent.

The task in front of the second UPA government is to design policy in such a fashion that further favourable structural changes can take place. One area of concern is government finances. Various government deficits have grown alarmingly in the past 12-18 months. Another area of concern is stalled demand. A third is inadequate infrastructure.

Good policy would have to address all three concerns. This is actually feasible. In the short term, a policy that successfully targets new infrastructure creation would get the economy buzzing again through the vast investments that infrastructure projects generate. At the same time, if the government can successfully conduct 3G auctions in telecom and reduce losses in the power sector, it could cut its own fiscal deficits.

A reasonably structured telecom 3G auction could pull in multi-billion US dollars in license fees and subsequent revenues and taxes. Realistically anywhere up to 3 per cent of gross domestic product (GDP) could be realised in a 3G auction.

Any policy that stems losses in the power sector could save around 3-4 per cent of GDP. Direct losses from inefficiencies in the power sector amount to that much. Another 1-2 per cent worth of downstream losses are due to outages that affect business output or force business to install backups.

If the UPA succeeded in doing either of these things, it would have a positive effect on the fiscal deficit. If it succeeded in doing both, it would dramatically reduce the consolidated (States + Centre) fiscal deficit. It would also in all probability, raise the trend growth rate significantly.

Obviously there are intractable political barriers to reforms in these two sectors. Telecom has been a victim of coalition politics that has led to changes in ministers causing inconsistent policy and hence, delays and litigation. Power has been a victim of its mixed constitutional status where every state has a local monopoly and the Centre also plays a large role. In both cases, independent regulators exist. They need to play a bigger role.

Naturally a focus on power and telecom should not mean that other sectors are neglected. The government definitely needs to speed up the pace of road-building for instance, and it needs to ensure that expansion plans of railways, ports and airports stay on schedule.

The UPA has a stronger mandate than any government since 1989. If it can leverage that into solutions in these two sectors, in fact, if it can turn around power alone, it will have done more than any government since 1991.

All infrastructure projects are capital intensive. Most are long-gestation and very policy-sensitive. Most involve the participation of a very large number of different businesses apart from the service providers themselves. For example, engineering and construction firms, equipment manufacturers, cement and steel makers, specialised financiers, etc, all come into play.

In fact, if you exclude a few sectors such as FMCG and pharmaceuticals, all sorts of businesses are involved in infrastructure. And the positive effects of better infrastructure are felt across the entire economy.

This is where UPA-II must focus. If it does so, India will ride out the current recession better than most because the structural changes will automatically raise the trend growth rate. One could make a case for specialised infrastructure funds if we assume this scenario. But one could also suggest that wide-angle index funds will do just as well.