Financial Times

GDP Growth-8 per cent or 10 per cent?
By Terrence Savundranayagam Retired Statistics Director, Central Bank
Manifestos of the two main Presidential candidates say they will take measures to increase GDP growth by 8 to 10 per cent. These growth rates are very high by historical standards. Sri Lanka has achieved growth rates of 8 per cent in only two years, 1968 and 1978 and growth rates of over 6 per cent in 1993 and 2000. In general GDP growth rates of around 5.6 per cent appear to have been the norm in good years. Hence the growth rates targeted in the two manifestos whether 8 per cent or 10 per cent are a quantum increase over the historical trend in GDP growth. The purpose of this article is to examine the feasibility of achieving the high growth rates projected in the two manifestos.

GDP is defined as the total value of goods and services produced in a country in a given period of time. The growth rate is the real increase (i.e. the money increase adjusted for prices) in the value of goods and services produced. Therefore the increase in GDP growth (the growth rate) is a measure of the increase in income, employment and welfare. The importance of having high GDP growth is therefore clear.

The GDP can be looked at from the production side (the value of goods and services produced) or the expenditure side (the value of expenditure on these goods and services). When looking at the GDP from the production side we have to consider whether increasing the production of goods and services by 8 or 10 per cent is feasible. In other words from what production sectors can these high rates of growth come.

In order to look at the prospects for high GDP growth we have made an estimate of GDP for the current year 2005 using data available up to September and projecting for the next three months. According to our estimates the GDP will increase by 5.4 percent this year (2005). We have then estimated GDP for 2006 using the 2005 estimate as a base.

In estimating GDP in 2006, we have assumed that the policies envisaged in the two manifestos will result in high increases in growth mainly in factory industry, small and medium scale industries and in services. In projecting the increase in service sector growth, we have assumed increases in government services and tourism that are well above their trend rate of growth. For the agricultural sector we have assumed increases in all crops based on past performances. The increases in the trade and transport sectors have taken into account the increases in production that have been assumed. On the basis of our estimates the maximum rate of GDP growth that can be achieved can be as high as 9 per cent. This estimate of GDP for 2006 is in fact an estimate of Potential GDP (in National Accounts, potential output is derived by breaking down real GDP growth into its cyclical and trend components). In this exercise however, we have estimated the highest rate of growth that can be achieved in each sector.

Our estimate of Potential GDP should be seen as a stand-alone estimate and not as a projection based on past trends. Since the growth rate of GDP for the year 2005 has been estimated at 5.5 per cent, achieving 9 per cent GDP growth in 2006 is virtually impossible. However the estimate of Potential GDP is a useful benchmark to evaluate the possibility of achieving growth rates of 8 to 10 per cent per year.

The increase in GDP growth of 9 per cent assumes a substantial increase in investment i.e. in Gross Domestic Capital Formation over present levels. In Sri Lanka the investment/GDP ratio has ranged from 22 to 25 per cent.
A growth rate of 9 per cent implies a very much larger increase in the Investment/GDP ratio (assuming productivity is unchanged). A large increase in the Investment/GDP ratio is critical if a high growth rate is to be achieved.
What then is the rate of investment required to achieve a high growth rate of 9 per cent.? To answer this, we have to look at the concept of the Incremental Capital Output Ratio (ICOR).

The ICOR is a measure of the productivity of capital and is obtained by dividing the Investment/GDP ratio by the growth rate of GDP. A higher ICOR means that capital has been less productively utilised and vice versa. Thus a higher GDP growth rate is possible with a lower ICOR and the same amount of investment. During the last three years the ICOR has averaged 4.5 per cent. We have used the average of the last three years because a reduction in the ICOR can only be brought about in the medium to long term). If the average ICOR of the last three years is assumed, the Investment/GDP ratio will have to increase to 40 per cent if GDP growth of 9 per cent is to be achieved. I do not think future policy measures will call for a drastic cut in consumption.

An evaluation of how realistic the projected high growth rates are then comes down to having a set of policies that will bring in a substantial amount of foreign investment. Hence high growth rates envisaged are critically dependent on creating a climate of investor confidence. In this context a speedy solution to the ethnic problem is imperative.

In the final analysis therefore the feasibility of achieving a GDP growth of 8 to 10 per cent depends not merely on having the right mix of economic policies. More crucial are the policies that will help to increase the inflow of foreign investment into he country i.e. policies that will bring about political stability and confidence in the long term future of the country. This is particularly important if high GDP growth is to be sustained over a number of years.
Our conclusion, when taking into account the constraints to high growth in the short term - a favourable investment climate, a large inflow of foreign investment, speedy and efficient utilisation of resources and an increase in the demand for our exports - is that GDP growth in 2006 can be at best around 6 to 7 per cent. However our study indicates that in the medium to long term, we can achieve GDP growth rates of over 8 per cent if the right policies are in place.

Perhaps it would be more realistic to evaluate policies in the Manifestos in terms of their commitment to increase the quality of economic growth. That is, high economic growth should be accompanied by participatory development, increased employment and good governance through accountable institutions and a transparent legal framework.

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