Lean times for Indian economy gurus

Swaminathan Aiyar has a piece in today's ET on how the mystery underlying the growth of the Indian economy. He says it is not clear why India should be growing at an average rate of 8.6% in recent years when there are still so many negatives in the scenario.

A different way of putting this would be to say-as I have been saying for long- that economic pundits have simply been wrong about the Indian economy. They warned us that there was no way the Indian economy could grow at 8% plus without "reforms". Many of these reforms have not been implemented or implemented in full. But that has not kept the economy from growing.

Aiyar mentions several hypotheses that attempt to explain the Indian economy's performance- "tipping point" or the cumulative effect of past reforms, steady improvement concealed by external shocks such as the east Asian crisis or the IT bus, the revival of manufacturing, the global boom. He is not sure they adequately explain the outcome. In particular, governance remains weak and the fiscal deficit is disconcertingly high.

I have never bought the governance thesis- that shifting coalitions or even political instability can be a growth inhibiting factor. Look around and you will find countries wracked by insurgencies doing quite well in terms of economic growth- Sri Lanka is a striking example. The fiscal deficit may be high in absolute terms but the trend towards improvement is unmistakeable.

I happen to think that the biggest factor in the improved performance of the Indian economy is the increase in savings and investment rates. The savings rate has risen by nearly 10 percentage points over the past decade. Fiscal improvement has been an important factor underlying the increase in the savings rate. Fiscal improvement, in turn, has been made possible by falling interest rates. And lower interest rates are the result of huge foreign inflows.

Why have foreign inflows risen so fast? Remittances have risen sharply after the exchange rate became market determined and hence it made sense to remit money through official channels and not through the havala route. FII flows have shot up as the stock market was modernised and foreigners realised that here was an economy that had grown at over 6% for two decades and would grow even faster. FDI has risen for the same reason. Falling interest rates have also boosted corporate profitability and corporate savings.

When an economy of India's size shows sustained growth, it becomes a magnet for global savings. Once the savings start pouring it, domestic savings rise because of the impact on the fisc and corporates of falling interest rates. The momentum imparted to the economy is sufficiently strong that it does not require "second generation" reforms. That's bad for economic pundits- they are left with little to preach. But it's just fine for the economy.

Would we have been even better off with a further dose of reforms? No- and here I think the political class got it right in preferring to move gradually. More reforms would have been socially disruptive- vocal segments would have been alienated and that would have created serious governance issues. The trick was to recognise the trend towards improvement and let the economy be. In this the politicians were right, the pundits wrong.

I have said this before: the performance of the Indian economy is ultimately a tribute to the democractic process and a warning against setting too much store by experets.