Talk:Economy of India/Goldman

Future predictions: "conventional wisdom" from Goldman Sachs

File:IndianEconomicForecast.SVG

Goldman Sachs has predicted that India will become 3rd largest economy of the world by 2035 based on predicted growth rate of 5.3 to 6.1%. Currently It is cruising at 9.4% growth rate.

In 1999, Goldman Sachs predicted that India's GDP in current prices will overtake France and Italy by 2020, Germany, UK and Russia by 2025 and Japan by 2035. By 2035 it is expected to reach as 3rd largest economy of the world behind US and China[1].

Goldman Sachs has made these predictions based on India's expected growth rate of 5.3 to 6.1% in various periods, whereas India is registering more than 9% growth rate. However the same report also shows there were large variation in its predicted gauging growth between 1960–2000, 7.5% predicted India's annual growth rate compared to the real average value of only 4.5% during that period.

A Goldman Sachs report recently cited by BBC News stated that 'India could overtake Britain and have the world's fifth largest economy within a decade as the country's growth accelerates' Jim O'Neal, head of the Global Economics Team at Goldman Sachs, said on the BBC, "In thirty years, India's workforce could be as big as that of the United States and China combined"

Future predictions taking purchasing power parity shifts into account

GDP sizes for US, China and India over the next few decades (at 2006 US dollars), taking purchasing power parity, growth trends and demographics into account.

Per capita income projections for US, China and India (at 2006 US dollars) over the next few decades, taking purchasing power parity, growth trends and demographics into account.

GDP growth at exchange rates

The Goldman Sachs report makes predictions about relative sizes of economies in 2025 or 2050 based on current exchange rate economy sizes, and ignores the effect of rapid decline in purchasing power parity ratios of economies as they approach maturity. The PPP ratio measures approxiamately how many times the cost of living is less in a given country as compared to in the US, and results in an artificial deflation of a GDP when measured at current exchange rates. However, the PPP ratio has historically always declined rapidly towards 1.0 (recent examples include Ireland, Japan, S. Korea, Taiwan, Singapore) when a rapidly industrializing country has caught up to even half of the level of US per-capita income in PPP terms. India and China's PPP ratios in 2005 were close to 5.0, and are now rapidly declining even as their undervalued currencies appreciate against the US dollar. This decline happens because of two reasons- (1) inflation, and (2) appreciation of the local currency. The two factors can happen simultaneously leading to exchange-rate level GDP growth rates that are much higher than the real GDP growth. This phenomena has resulted in recent doubling of India's GDP as measured in exchange rate dollars, every 3.5 years or so. It is important to note that we are not talking about real GDP growth at this point but are looking at economic growth in exchange-rate terms- which is important if we are comparing the sizes of two economies in exchange rate dollars, as the Goldman Sach's report does. Later parts of this section discusses real GDP growth in PPP (which is inflation, price, and exchange rate adjusted by definition) terms.

Let us take an example from 2006-2007 GDP growth for India. Note that the real GDP growth (which is hard to measure directly) is calculated using the nominal gdp growth (which is easy to measure) minus the inflation (which is also measured directly). The real 2006-07 GDP growth for India was 9.4 percent, and the annual inflation was around 5%. The nominal GDP growth in Rupees was 9.4+5=14.5 percent. On top of that, Indian Rupees appreciated by 10% between 2006-2007 against the US dollar, resulting in a total economic output as measured in nominal (2007 exchange rate) US dollars in 2007 as = (1+ 14.5%) x (1+10%) times of exchange rate economy of 2006 = 1.2595 times of 2006. In other words, the size of the Indian economy grew by 25.95 percent in 2006-07 in nominal dollar terms. If we adjust for the 3% loss of value of the real US dollar in 2006-2007 due to inflation in US, these numbers for the Indian economy still add up to 22.3% GDP growth in constant 2006 dollar terms.

This is the reason why India's GDP went from less than 800 billion US$ in 2006 to over a trillion US$ in 2007. At this point the question arises- what is the root cause of this apparent dichotomy between real GDP growth and exchange rate GDP growth? The heart of the difference stems from the purchasing power parity ratio. The PPP ratio for India for 2006 was 4.5, i.e. the cost of living in India was estimated to be over 4.5 times cheaper than in US in 2006. The PPP ratio would remain unchanged if the Indian Rupee did not appreciate and if the inflation rate in Indian and US were to remain the same. However, as can be see from the data above, despite India having a higher inflation rate in 2006-07 of around 5% (as compared to 3% in US), the Rupee still appreciated by around 10% against the US dollar. This is what resulted in the purchasing power parity to actually decline in 2007 as compared to 2006. And it can be shown that this decline would be = (2006 PPP ratio) x (2006-07 real GDP growth)/(2006-07 exchange rate GDP growth)= 4.5 x 1.094/1.223 = 4.03.

The usually large PPP ratios for underdeveloped economies is linked to the fact that they are underdeveloped- to varying degrees both in terms physical infrastructure and human capital. On top of that, political and social factors often prevent them from developing rapidly, despite the obvious need for better infrastructure, human development etc. However, when many such economies (e.g Ireland, Japan, S. Korea, Taiwan, Singapore and others in the recent past) transition and reach a certain critical level of social and economic development, the bottlenecks to their growth get removed, and the human and physical resource utilization goes up suddenly and is often self-reinforcing. This results in increasing demand, productivity, and wealth in that order, resulting in the price of human capital going up. This causes the PPP ratio to then rapidly decline towards 1.0.

[Comment: There is strong evidence that India and China are now experiencing this phenomena, and most experts agree that they have crossed such a threshold in human development, and their high growth phase (now in the third decade for China and second decade for India) is not temporary. Also, both Chinese and Indian currencies are now under strong pressure to appreciate.]

This decline in PPP ratio year over year is what causes observed exchange rate GDP growth numbers that are substantially larger than those described by reports such as Goldman Sachs above. Note that there is no actual acceleration in economic growth because of the decline in the PPP ratio, which only causes the exchange-rate GDP numbers to ramp up at a faster pace, causing such economies to rapidly overtake smaller developed economies in GDP rankings when measured at exchange-rates.

Ignoring the effect just described above, many conventional predictions use two incompatible quantities in their computations: (1) the real GDP growth of a country corresponding to the PPP is used as a basis for growth rate estimates, and (2) the current exchange-rate GDP is used as the base economy size. Such a simulation then "grows" the economy every year by increasing the exchange rate GDP base by the real GDP growth rate. For example, such a simulation, starting from the 800 billion Indian economy of early 2006- would predict an 875 billion economy in early 2007 using the 9.4% real GDP growth, as opposed to the over US $1 trillion Indian economy actually observed in early 2007. Thus, such an extrapolation of GDP growth based on past "local" growth does not take into account the decline in PPP ratios as an economy develops, hugely underestimating the GDP growth at exchange rates that actually occurs. Because of the exponential nature of economic growth, the error accumulates very quickly as the predictions are stretched further into the future, resulting in quixotic numbers such as "India's GDP to overtake UK's by 2025"- that are conservative compared to the reality by decades.

Real GDP growth projections in PPP terms

A more realistic projection of future per-capita could simply be based on two compatible quantities- the current economy size as measured in PPP, and the real growth-rate. Based on PPP growth, the Chinese GDP is set to cross the US economy to become the largest in the World between 2009 and 2010, in merely 2 to 3 years from now. Similarly India's GDP has already crossed Japan's to become the third largest. Making projections into the future, India is set to cross US economy at PPP around 2024 (at 10 percent annual growth for India, 3 percent for US. There is substantial evidence looking at Chinese, Taiwanese, S. Korean and Japanese history that India's economy has just crossed a growth bottleneck, and that the actual growth rates for India might be even higher and would sustain for decades, making this crossing even earlier and even more dramatic"). When India becomes larger than the US economy, India's per capita income would still be ~1/4 of US income at that time; for the reasons mentioned above, it is likely that it would still be growing close to its current pace when it crosses US to become the second largest economy in the World, 16-17 years from now.