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.
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.
The column originally appeared in Vivek Kaul’s Diary on August 18, 2016