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India's Economic Growth and the Power of Compounding

Aug 18, 2016

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On August 2, 2016, I had talked about a bungalow on the posh Nepean Sea Road in Mumbai, being up for sale.

The bungalow was last sold in 1917, at a price of over Rs 1 lakh. Further, similar properties in the vicinity in the recent past had been sold for Rs 400 crore, or so, The Times of India reported.

Essentially, something that was bought for around Rs 1 lakh, 99 years back, is now expected to be sold for around Rs 400 crore.

This works out to a return of 11.3 per cent per year.

How how much would have the bungalow been worth now in 2016, if the rate of return had been just 30 basis points lower, at 11 per cent per year? One basis point is one hundredth of a percentage.

Would like to take a guess, dear reader?

Rs 395 crore? Or Rs 375 crore? Or even lower than that?

In fact, the answer will surprise you.

At a return of 11 per cent per year, the bungalow would have been worth around Rs 306.9 crore, or almost Rs 93.1 crore lower.

This would mean that the bungalow would be worth 23.3 per cent lower in comparison to Rs 400 crore.

And how much would the bungalow be worth at a return of 10.5 per cent per year? Would you like to take a guess?

Actually let me not prolong the agony. At 10.5 per cent per year, the bungalow would have been worth around Rs 196.3 crore. This is less than half of Rs 400 crore. Hence, a fall in return of 80 basis points per year, wipes off the value by more than half, over a 99-year period.

And how much would the bungalow be worth at 10 per cent per year? Rs 125.3 crore. This is around 68.7 per cent lower than Rs 400 crore.

So what is the point I am trying to make here? This is what the power of compounding can do. Even a small difference in return over a long period of time can make a huge difference to the amount of corpus you end up accumulating.

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Of course, a normal person who is trying to accumulate wealth does not invest over a 100-year time frame. And further, even if he or she did, there is no way of knowing in advance what strategy would work best, over such a longish period of time.

Nevertheless, this piece is not about which is the best investment strategy in the long run. It is about the fact that what applies to investment returns also applies to the economic growth rate. Even a small difference in the annual economic growth rate over a longish period of time, can have a huge impact on how a country eventually turns out to be.

As Vijay Joshi writes in India's Long Road-The Search for Prosperity: "The 'power of compound interest' over long periods is such that even a small change in the growth rate of per capita income makes a big difference to eventual income per head."

And how do things look for India? Where would it end by 2040 at different rates of economic growth? As Joshi writes: "At a growth rate of 3 per cent a year, income per head would double, and reach about the same level as China's per capita income today. At a growth rate of 6 per cent a year, income per head would quadruple to a level around that enjoyed by Chile, Malaysia and Poland today. If income per head grew at 9 per cent a year, it would increase nearly eight-fold, and India would have a per capita income comparable to an average high-income country of today."

The question is what will make India a prosperous country. How do we define prosperity? As Joshi writes: "At a first pass, it could be defined as the level of per capita income enjoyed by the lower rung of high-income countries today, with the rider that national income should be widely shared and even the poorest people should have decent standards of living. To reach the said goal, India would require high-quality per-capita growth of income of around 7 per cent a year for a period of twenty-four years, from 2016."

The trouble is that there is almost no track record of any country (except China) growing at a rapid rate of 7 per cent per year, for a very long period of time, which is what India needs to achieve if it has to be prosperous.

When it comes to superfast growth China grew by 8.1 per cent per year between 1977 and 2010. Only two other countries came anywhere near. As Lant Pritchett and Lawrence H. Summers write in a research paper titled Asiaphoria Meets Regression to the Mean: "There are essentially only two countries with episodes even close to China's current duration. Taiwan had a growth episode from 1962 to 1994 of 6.8 per cent (decelerating to growth of 3.5 percent from 1994 to 2010). Korea had an episode from 1962 to 1982 followed by another acceleration in 1982 until 1991 when growth decelerated to 4.48 percent-a total of 29 years of super-rapid growth (>6 per cent)-followed by still rapid (>4 per cent) growth. So, China's experience from 1977 to 2010 already holds the distinction of being the only instance, quite possibly in the history of mankind, but certainly in the data, with a sustained episode of super-rapid (> 6 per cent per annum) growth for more than 32 years."

Hence, the odds are stacked against India. And it will mean the governments doing many things right in the years to come, if the country has to get anywhere near a sustained growth rate of 7 per cent or more, for a longish period of time.

The trouble though is that most policymakers seem to take a growth rate of 7 to 8 per cent as a given, in their calculations, even though history shows otherwise.

Vivek Kaul is the Editor of the Diary and The Vivek Kaul Letter. Vivek is a writer who has worked at senior positions with the Daily News and Analysis (DNA) and The Economic Times, in the past. He is the author of the Easy Money trilogy. The latest book in the trilogy Easy Money: The Greatest Ponzi Scheme Ever and How It Is Set to Destroy the Global Financial System was published in March 2015. The books were bestsellers on Amazon. His writing has also appeared in The Times of India, The Hindu, The Hindu Business Line, Business World, Business Today, India Today, Business Standard, Forbes India, Deccan Chronicle, The Asian Age, Mutual Fund Insight, Wealth Insight, Swarajya, Bangalore Mirror among others.

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6 Responses to "India's Economic Growth and the Power of Compounding"

malcolm

Aug 19, 2016

Interesting, valuable analysis.

Like 

tally

Aug 18, 2016

It is a tall order to achieve 7-8% sustained growth rate for 20 - 25 years. We must recognize few basic differences between China and India. China has almost three times larger than India and has has many times exploitable natural resources than India. Take example of oil & gas. China has forth largest reserves of crude & gas, whereas India has almost nil. This example can be replicated for many other resources. At some point of time both the countries had similar GDP but China's poorest were much better. India's poorest have been poor have been mass exploited for centuries. This has stunned their physical and mental growth. It is stated that if these class has to be brought up to some kind of average than couple of generation are required. In absence of population control we will catch up with China in next 8-10 years thereby diluting per capita income. Our culture also encourages mediocrity thereby lower efficiency and substandard production coupled with lack of innovation. Social and religious tensions also are impediments to our faster growth rate. I do not wish write a full write up therefore in short our progress has many impediments but scope for faster growth exist with right mix of economic policies specially for the poorest.

Like (1)

Ramesh B

Aug 18, 2016

excellent, Sir !

Like (1)

Thiruvalluvan

Aug 18, 2016

Will you please give us the details of the status of the poorest of the poor in those countries today ( Taiwan, Korea & China)? I feel that will be a worth thing to do.

Like (1)

jagadishchandra

Aug 18, 2016

Dear Vivek,
The power of compounding is always existed. But with my experience in investing in equity only safest is systematic investing in mutual funds and reinvesting the bank FDs. I am sorry to say most of the retail investors are mislead by so called financial experts and retail investors loss money in these stocks. I dont know but it looks like only some big investors are profiting from these recommendations. so for safe bets are SIP in Mutual funds and reinvesting in Bank FDs as they mature.
reagrds

Like (1)

Vipul Jasani

Aug 18, 2016

Hi Vivek,

we need to get out of this nonsense GDP growth. As long as we measure success based on GDP growth, we will remain what we are today i.e. fruits will be taken only by rich people and overall quality of life of common man will only gets deteriorated. Also it will increase the terroirsm and crimes in society due to increase in inequality between rich and poor.

Each country has different culture, life style etc. and therefore GDP growth can not be general parameter of success for every country.

Thanks

Like (1)
  
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