Demographic changes can boost India's growth

It is a good idea now and then to lift our eyes from the minutiae of the present and look at the big picture further ahead.

We know that if India is to reduce poverty rapidly, the annual growth rate of national income must rise from 6 per cent to 8 per cent or more. How is that to be achieved?

In this article, we focus on one simple point. In raising the growth rate, India's demographic profile presents both a huge opportunity and a huge challenge.

Three Stages

The demographic opportunity is created by the transition from high to low rates of fertility and mortality. Western Europe took 200 years to complete this process. Many developing countries are compressing it into three generations.

The critical point is that changes in fertility and mortality are asynchronous. Mortality rates (especially infant mortality rates) fall earlier and fast; fertility rates fall later and slowly.

As a result a bulge is created in the population of young people, which then works its way through the age-distribution. Thus, in a stylised account, a country's demographic transition would go through three stages:

• In the first stage, the proportion of young people in the population rises.
• In the second stage, the proportion of young people declines, that of the old increases modestly, and that of adults of working age increases significantly.
• In the third stage, the proportion of working-age adults falls while that of old people rises.

Japan and parts of Western Europe are now entering the third stage: they are ageing rapidly. (For example, in Japan, the working-age population is expected to decline from 68 per cent to 59 per cent by 2020). Most of East and South-East Asia is now in the middle of the second stage.

Around 2010, the share of working-age adults in the populations of East Asia will stabilise and then decline.

India, in contrast, is just entering the second stage and its share of the working age population is expected to increase until 2035 and beyond.

Importantly India is currently at an inflection point at which the increase in the share of labour force is set to accelerate.

Note also that India's share overtakes that of Japan around 2010, and that of China around 2030.

Age-Distribution, Savings and Growth

Demographic changes are important for growth because there is a clear connection between the age-distribution of the population and the national rate of saving. The working population has a much higher propensity to save than the dependent population (young and old).

Consequently, when the demographic bulge raises the share of working-age adults in the population, the overall propensity to save rises sharply. This is a major explanation, among others, of the phenomenal increases in national saving rates in East Asia in the last three decades to 30 per cent or more. (We must remember also that the savings-growth dynamic is self-reinforcing. Increased saving raises the growth rate; the rise in the growth rate in turn boosts the rate of saving.)

But over the next two decades, East Asian savings rates will fall as their old-age dependency rates rise. In Japan, the savings rate has already fallen. The same can be expected in Western Europe and the US in due course.

India's national savings have risen over the last two decades from 19 per cent to 23.5 per cent of national income. But the composition is revealing.

Household savings have risen sharply from 14 per cent to 22 per cent and corporate savings from 1.5 per cent to 4 per cent; public savings, however, have fallen from 3.5 per cent to minus 2.5 per cent.

The expected demographic trends suggest, in the light of experience elsewhere, that over the next decade India's national savings rate could rise to around 30 per cent if public savings do not fall further, and to about 32 per cent if public dissaving is eliminated.

If the gross investment to output ratio remains at the current level of 4, it follows that the growth rate could increase from 6 per cent to 8 per cent per year over the next decade. This scenario is based on a few assumptions. One plausible and fairly conservative assumption is that economic reform will continue and prevent any decline in the productivity of investment.

The calculation is of course crude and purely illustrative. The main point is that India's demographic profile contains a potential for increasing the growth rate via an increase in the rate of saving.

The Challenge

Two other assumptions in the above argument are more crucial. The first is that investment keeps pace with savings. Savings will run to waste (indeed will not be realised) unless the desire to invest is sustained.

The second is that growth is sufficiently labour-demanding to employ the forthcoming large increases in the labour force.

Correspondingly, these are also the two big challenges for policymakers. Many policies are relevant for meeting these challenges. We focus on a few. The inducement to invest can evaporate if interest rates are too high. There is sometimes a legitimate worry that low interest rates can be inflationary.

But low interest rates and a relaxed monetary policy are consistent with low inflation if savings are rising rapidly. Investment also requires large and growing markets. The world market is much larger than the home market, so it is important to pursue liberal trade policies.

The allocation of investment also matters, so financial sector reform has to be kept going. As noted above, it is vital to ensure that growth is labour-demanding. Trade liberalisation and outward-orientation are no less essential for this purpose than they are for encouraging investment.

Other relevant policies for increasing the demand for labour include promoting flexible labour markets and increasing educational opportunities substantially.

The bottom line is as follows. India faces a highly favourable demographic prospect. If harnessed, it could lead to a virtuous circle of higher saving, investment and growth. If not, the prospect is of disappointing growth, probably accompanied by rising unemployment.

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