Monetising the output gap in Indian economy

An economy is said to be on the growth trajectory only when it is closely operating at potential levels of output. What could boost these growth rates in the economy? After the financial crisis the large economies of the world observed a continued sizeable output gap. A look at the World Bank estimates, one can find only Germany and the UK, near to closing the output gap, while France and Japan are still much behind the drift.

What exactly is this output gap? Output  gap is the difference  between what an economy can produce and what it is producing. The policy makers are not only concerned about the output of goods and services which is measured as GDP, but also about the potential output. Hence they are concerned about how close an economy’s current output to its potential one.

The difference between the actual output of an economy and its potential output is termed as output gap. Potential output is what an economy can churn out in terms of goods and services to its maximum at its full capacity and efficiency. An output gap signifies that  the economy is running inefficiently, either overworking, which  is  positive  or  underworking its resources, which are negative. A positive gap indicates  that  there is a huge demand and  that it has to put the resources to most efficient capacity to meet the demand. A negative gap indicates that there is a weak demand and hence there is a spare capacity or slack in the economy.

How do we measure the gap? There are two measures often used by the policymakers to gauge the output  gap namely — inflation and unemployment. The logic is simple. When there is a positive output gap, prices begin to rise in response to demand pressure. Similarly, if there is negative gap over time, the prices will begin to fall to reflect weak demand. For many central banks, maintaining full employment becomes an important policy goal at the same time bringing inflation under control.
But, does the global output gap influence domestic  prices? The answer is stil  yes. In an increasingly integrated  world economy, the global output gap can affect domestic inflation and employment. This calls for  the central  banks  to  pay  close  attention  to  developments in the growth potential  of  the  world economies other than domestic labourand capital.

Now  the  question  is,  where  do  we  stand  in terms of global  economy? Economies  across  the  world are trying to close this output gap through policy changes to address the level of spare capacity. The recent $95 billion infrastructure commitment in Canada or the ECB stimulus packages are more direct approaches.

Recently, head of the IMF Christine Lagarde  said, “Investing  badly-needed,  but well-designed infrastructure is an obvious area of great potential. Building or upgrading the infrastructure in the short term can boost the aggregate demand through increased construction activity and increased employment can boost economic growth by increasing the potential supply capacity of an economy. Literature supports the concept-one extra dollar spent on infrastructure could increase GDP by $2.5 to $3.5 in the long run. Can infrastructure investments reduce the output gap? Of late, many policy measures have been taken by the govt. for enabling environment for industrial growth.

Initiatives like ‘Make in India’ and ‘Smart Cities’ will provide impetus to the industrial  sector, which  is  considered to be the key driver of economic  growth, which  would  help  in transforming infrastructure. Investing more in infrastructure is a potential and attractive approach to boost up growth rates, against boosting short term demand. Growth can happen when investment is in line with the economic, social and environmental objectives, aligned with government goals. This sort of investment offers an acceptable return on capital and also benefits directly or indirectly  the  wider economy in the long run.

Spending on these infrastructure initiatives creates jobs, and job growth leads to an increase in consumer demand, which in turn affects GDP growth and its stability. Infrastructure investment in India picked up starting with the Golden Quadrilateral Highway construction in 2001. Since then, the economy demonstrated an ability to generate 7.5 million new jobs annually in 12 years starting from 2000, and the employment in construction jumped from 26 million to 50 million.

Investment  in infrastructure as a percentage of GDP increased from 4.9% in 2002-03 to about 7.2% in 2011-12, and is  expected to reach 10% of GDP by 2016-17, as per a CII report. The government  is  taking every possible initiative to boost the infrastructure sector. The  Construction  Industry  Development  Board  (CIDB) of Malaysia has proposed to invest $30 billion  in  urban  development  and  housing  projects  in  India, such  as  a  mini-smart  city  adjacent  to New Delhi Railway Station, a green city project at Garhmukhteshwar in Uttar Pradesh and the Ganga cleaning projects. All these initiatives are expected to generate immense employment opportunities and in turn increase productivity reducing the output gap.

The challenges: As per the IBEF report, India needs Rs 31 lakh crore to be spent on infrastructure over next five years.The challenge lies in prioritising the infrastructure with the limited funding resources.

Another challenge today is delay in implementation of these projects.The infrastructure unit must be empowered. However, the government initiated Infrastructure Investment Trusts aimed at raising about  Rs 4,035 crore through its IPO. There are many other infrastructure firms to gear up to these trusts. This could reduce the funding problems to certain extent. Some changes should   be brought  about in the bidding of construction contractors like benchmarking and standardisation to enhance the quality of projects.Infrastructure  can  be  looked  as  an  economic enabler than a panacea. These investments make people more efficient and productive with their time.

(The writer is Professor in finance at Christ University, Bengaluru)