Compounding India to prosperity in new term

India’s economy has now reached a critical mass where the compounding process can dramatically enhance both per capita income as well as sheer bulk

Prime Minister Narendra Modi returns to office at a particularly important stage in India’s economic trajectory when the compounding process of growth will begin to generate extraordinary results. Most readers will be familiar with the concept of compounding but, even the mathematically adept, tend to underestimate its power. Therefore, a bit of history is in order.

When India began to reform its economy in 1991-92, its GDP amounted to just $270 billion in nominal terms. (AFP)

When India began to reform its economy in 1991-92, its GDP amounted to just $270 billion in nominal terms. It then took 16 years for the economy to cross the $1 trillion mark for the first time in 2007-08. The next trillion dollars were added in just seven years when GDP crossed $2 trillion in 2014-15. Another trillion should have been faster but two years were lost in the Covid-19 pandemic; the $3 trillion milestone was crossed in 2021-22. Then, with the economy recovering strongly in the post-Covid period, India’s GDP took a mere three years to add the next trillion and is expected to cross $4 trillion in 2024-25.

Unless there is a major unexpected shock, India’s economy will add the next trillion dollars in a bit more than two years. When India crosses the $5 trillion mark, it will have bypassed Japan and Germany to emerge as the world’s third-largest economy. If we manage to just maintain our current pace for a generation, India’s GDP would reach the $29-33 trillion range by 2047.

Even as India’s GDP has grown, its share of the world economy has increased. In order to correct for distortions from relative prices and exchange rates, this is best understood in purchasing power parity (PPP) terms. In 1980, the US was the world’s dominant economy with a 21% share of world GDP in PPP terms. India’s share was just 3% and China, after the chaos of the Mao years, was down at 2.3%.

Improved policies in China from the 1980s, and in India from the 1990s, led to better performance. China’s share jumped to 7.2% by 2000, and it equalled the US’s share of 16% in 2017. Today, it accounts for 19.4% of the global economy, the world’s largest economy in PPP terms. The US is still the world’s largest economy in nominal dollar terms but in PPP terms its share is now down to 15.5%. Meanwhile, India’s share has risen from 4.3% in 2000 to almost 8% in 2024. This is not only the third largest but is already more than half the size of the US economy in PPP terms!

Despite the recent growth performance, India remains a poor country with per capita income at a mere $2,750 in nominal terms, and $10,100 in PPP terms (IMF estimates). But note that China was at similar levels just 16 years ago in nominal terms, and a mere 12 years ago in PPP terms. The point is that the gap is the result of compounding. With India now growing at a faster pace than China, closing the gap is mostly about sustaining the compounding process.

India’s GDP grew by a remarkably strong 8.2% in 2023-24 and is expected to grow by 7% in 2024-25. This is the fastest pace of any major economy. Some economists have recently suggested that India enjoys strong growth just because it is poor and is “catching-up”. This is plainly misleading: India was even poorer in the 1960s and 1970s but did not witness high growth. There is nothing preordained about growth and every step needs to be earned. Policies matter, and sustaining the compounding process over decades will need continuous effort.

The first focus area for the incoming government would be to keep enhancing the supply-side of the economy. This requires continued investment in hard and soft infrastructure, improvements in ease-of-doing-business, process reforms, and, most importantly, structural reform of the administrative and legal systems. No amount of demand pumping can substitute for supply-side improvements. Moreover, this should be done across all sectors. There is no reason to abandon the manufacturing and construction sectors on the misplaced idea that an exclusive focus on services will create the necessary jobs.

Second, policymakers must remain conservative on macro-stability. Over the last decade, India has cleaned up its banks, anchored its inflation, accumulated a pile of foreign exchange reserves (currently $648 billion), and kept external debt well within manageable limits. Despite the unavoidable spike during the Covid-19 pandemic, the fiscal deficit is now steadily coming down. This is no small turnaround for a country that was considered one of the “fragile five” a decade ago. Macro-stability is crucial for sustaining the compounding process over long periods. The Asian Crisis of 1997-98 derailed several Southeast Asian countries that were once considered “tiger economies”. They never quite recovered their momentum.

Third, policymakers should remain focused on the eradication of absolute poverty (i.e. antyodaya) and not get distracted by western debates about “inequality”. This will require targeted support for the poorest segments through direct benefits transfer, safety nets, mission-mode schemes (especially for health/skills) and so on. This is a fundamentally different approach from the western “inequality” approach that gets caught in the quagmire of inheritance tax and wealth tax. Many of these ideas were tried in India in the past and had to be abandoned. Indian policymakers should never again fall into the old trap of trying to redistribute poverty.

To conclude, India’s economy has now reached a critical mass where the compounding process can dramatically enhance both per capita income as well as sheer bulk. The game is to sustain this process over a generation without getting distracted. In turn, this will require supply-side reforms and investment, macro-stability prudence, and direct efforts to eradicate absolute poverty.

Sanjeev Sanyal is member, Economic Advisory Council to the Prime Minister. The views expressed are personal