Potential Growth Rate of India

Why in the News?

India’s first quarter GDP growth for 2025–26 was reported at 7.8%, sparking debate on whether the country’s potential growth rate, estimated at 6.5%, needs to be revised. Despite the strong quarterly performance, experts argue that the long-term potential remains unchanged due to structural factors.

What Is Potential Growth Rate?

1. The potential growth rate is the highest rate at which an economy can grow over the long term without causing inflation or economic instability.
2. It reflects the maximum sustainable growth based on the economy’s resources like labor, capital, and productivity.
3. It is different from the actual growth rate, which is the real growth achieved in a specific period.
4. Actual growth can be higher or lower than potential growth due to short-term factors like demand, government spending, or global conditions.

Key Components of Potential Growth Rate

1. Gross Fixed Capital Formation Rate (GFCFR)
   1. This refers to the percentage of GDP that is invested in fixed assets like buildings, machinery, infrastructure, etc.
   2. A higher GFCFR means more investment in productive capacity, which can lead to higher growth.
2. Incremental Capital-Output Ratio (ICOR):
   1. ICOR measures how efficiently capital is used to produce output.
   2. It is calculated by dividing the investment rate (GFCFR) by the GDP growth rate.
   3. A lower ICOR means capital is being used more efficiently, leading to higher growth.
3. Potential growth rate can be estimated using the formula: GFCFR / ICOR.
4. For example, if GFCFR is6% and ICOR is 5.2, the potential growth rate is around 6.5%.

India’s Recent Growth Performance

1. ICOR for 2025-26 is estimated at 2, indicating moderate capital efficiency.
2. GFCFR has remained stable, meaning investment levels haven’t significantly increased.
3. So, potential growth remains at 5%.
4. To raise potential growth:
   1. GFCFR must increase (more investment)
   2. ICOR must decrease (better use of capital)

Sectoral Contributions

Growth in different sectors affects the overall potential:

1. Manufacturing: Improved performance in Q1 2025–26 (7.7%) compared to previous years (5.8%).
2. Services:
   8. Trade & Transport:6% (earlier average 13%).
   9. Finance & Real Estate:5% (earlier ~11%).
   10. Public Administration: 8% (earlier ~13%).
3. Public Sector: Government investment has increased, especially in infrastructure. But growth in capital expenditure is slowing down (from around 39% in 2021–22 to around 11% in 2024–25).
4. Private Sector: Share in total investment has declined from 37% to ~34%. Reviving private investment is crucial for long-term growth.
5. External Factors and Trade Challenges: Net Exports turned negative in Q1 2025–26, reducing overall growth due to uncertainties (tariffs and supply chain issues) in global trade.
6. Technology and Future Prospects: Technologies like Artificial Intelligence (AI) and Generative AI can boost productivity but for that, the older capital will need faster replacement which will lead to increased costs. This may balance out the effects keeping potential growth near 6.5%.

While some sectors are growing, they are still below their previous highs. Sustained improvement across all sectors is needed to raise potential growth.

Challenges and Way Forward

Conclusion

India’s potential growth rate of 6.5% is a realistic benchmark in the current global and domestic context. However, to meet employment and development goals, raising this ceiling is essential. This calls for revitalizing private investment, enhancing productivity, and adopting forward-looking policies.