GDP Puzzle II: 2015-16

Introduction

   With the latest GDP estimates surprising the market, analysts have suddenly noticed that there is such a thing as discrepancy. Based on this, a wide range of completely desperate conclusions are being drawn about GDP growth. Estimates of 5% to 8% are being bandied around. The hoary issue of new versus old system of GDP measurement has again been dis-interred. This note tries to clarify the new issues raised.[i]

GDP Measurement

  GDP is estimated from supply side by aggregating the vale added in different sectors such as Agriculture manufacturing(nanf), electrcity (elec) and construction(const) and from Demand Side by aggregating private consumption(C), government consumption (G), total investment (I)and exports (X)  minus imports(M). The difference between the two estimates is shown as a discrepancy(Disc). Mathematically these can be represented as,

Supply side estimate of GDP = GVA + Tax -Subs

           = GVA (Agri + Manf + elec + Const+...) + (Tax - Subs) 

         where Tax = Producer Taxes and Subs = Producer Subsidy.

Demand Side estimate of GDP= C+G + I +(X-M)

Discrepancy = GDP (demand side) - GDP (supply side)

    The data basis for supply side estimation is historically better, in India, than for demand side estimates, so the discrepancy is shown in the demand side estimates.  Over the past four years 2012-13 to 2015-16 the average growth of GDP ( in constant 2011-12 prices) as measured by the supply side has been 6.8% per annum, 0.5% point faster than GDP growth  of 6.3%  measured by the demand side.  In contrast the average growth in nominal terms is an identical 11.7% from both supply and demand sides.  Thus the difference in real growth rates is entirely due to the 0.5% difference in the price deflators: The supply side price deflator (inflation) has averaged 4.6%, while the demand side deflator has averaged a higher 5.1%.  As the difference in inflation is the largest in 2015-16 (3.7% - 1.1% = 2.6%) the real growth differential is also the highest in 2015-16 (5.2% - 7.6% = - 2.4% ). 

   In 2015-16 real GDP as measured from demand side has grown by 2.4% points slower than the real GDP as measured from supply side, because inflation (deflator) as estimated from the demand side is 2.6% points higher than the inflation (deflator) as measured from supply side.  Thus a majority of the producer sectors of the Indian economy were characterized by deflation ranging from -1.1% to -2.6%.  In contrast consumption demand (private & public) was characterized by positive inflation ranging from 3.1% to 4.5%, with only investment and external trade (Import & export) showing deflation.

For those inclined to blame everything on the change from old method to new method, the following comparison is useful: The discrepancies in current prices in the new accounts for 2011-12, were only 0.72, of the errors and omissions in the old accounts. The numbers for 2012-3 and 2013-4 (0.08 and 0.04 respectively) possibly because the revisions to the old accounts became redundant with the arrival of new ones.

    The UN-IMF system of GDP accounting was devised during a period of positive inflation, when few thought 90% of World could face deflation in several parts of the economy and for periods ranging to  year or more. In normal times various indicators of inflation diverge temporarily and converge either on annual basis or even on a moving average basis. This was the case in India for the Wholesale price index and the different indicators of CPI. Since the Global financial, the latter along with the new CPI index, have diverged progressively from the WPI (even adjusted for different weights) and shows no signs of converging. These divergences have translated into divergences in the deflators for different sectors and demand components. This methodological problem is probably most acute in transition from inflation to deflation and the reverse. I would hypothesize that the inflation-deflation dynamics is likely one reason for the increasing gaps.

Quarterly Data

  When we move from Annual GDP to Quarterly GDP the data basis is even weaker as much data is available (minimum acceptable quality) only on annual basis. Quarterly data is useful for judging trends in different components on the supply side and the demand side, though the latter are even poorer than in the annual data.  The quarterly trends for GDP & components are most useful when FY Q2 & Q3 data becomes available, least for Q4 (as full FY available). This is partly because the UN-IMF NAS/ GDP methodology that we follow, has technical rules for certain estimates in quarterly acts which r confusing even to users.   These are pragmatic rules of thumb based on historical experience.

  Analysts have made too much of a deal of GDP growth in the fourth quarter: Both the 7.9% growth shown by the supply side and the 5.4% growth shown by the demand side.  More significantly the  quarterly data show that during the second year of drought, private consumption maintains it slow but steady recovery, while gross fixed investment remains on a downtrend with large quarterly fluctuations.

Conclusion

     The annual data for 2015-16 confirms the estimate of 7.6% GDP growth that the CSO had estimated in February 2016.  This strengthens the confidence I have in the forecast I made at end-march 2016, before the forecasts of the monsoon appeared (based on the history of consecutive droughts). [ii] To summarixe:

(1)    That GDP growth in 2016-17 will accelerate to between 7.8% and 8.1%.

(2)     Growth  will be much more evenly distributed than in the past two years, with both the agricultural sector and the large corporate sector accelerating more than the rest of the economy.

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A version of this article appeared on the Op Ed page of the Indian Express dated 13th June, 2016 under the banner, "Gross Domestic Perplexity".  http://indianexpress.com/article/opinion/columns/gross-domestic-product-inflation-indian-economy-growth-variations-column-2849408/  .

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[i]  For the old one see http://dravirmani.blogspot.in/2015/09/indian-economic-growth-post-gfc.html

[ii]  http://dravirmani.blogspot.in/2016/04/growth-inflation-and-monetary-policy.html

OBOR: Economic, Diplomatic and Strategic Dimensions

INTRODUCTION

   OBOR was presented to the world by China in March 2015, as a comprehensive infrastructure & economic development program.[i] Its land component, the new Silk Road, echoes ESCAP's Asian highway, Asian Railway and Asian Economic Corridor Plans from the 1980s and 1990s.[ii] But more importantly it fills in what may be considered missing links, connecting China to the rest of Asia and into Europe.[iii] The naval parts echo what was termed the "String of Pearls" in the Indian Ocean, but extends these Westwards to Europe through the Red Sea and Eastwards to the South China Sea.[iv] Questions and concerns have however been raised about its less defined Strategic aspects, just as they were raised about the "String of Pearls," which was also presented as an economic infrastructure project for development of ports.

ECONOMIC Aspects

     The economic development part is driven and supported by massive overcapacity in China's manufacturing and construction industries and zero or negative returns to domestic investment (on the margin). Thus the opportunity cost of funds is low enough to allow low profit, high economic risk, investment in foreign infrastructure that could support its quest for future raw materials supplies and open its markets to sale of manufactured goods; a modern version of the Prebisch-Singer hypothesis of trade between the colonial "Center" and the colonized  "Periphery".  As current account surpluses are a basic feature of the existing "party capitalism" model of development, a moderate reduction of foreign exchange reserves through capital outflows, still leaves substantial net foreign exchange assets to finance the foreign exchange costs of these investments.  As much of the foreign investment in OBOR will be done by Chinese companies, Chinese labor and Chinese materials, the foreign exchange component is a small fraction of the total cost of these projects. The primary purpose of AIIB is therefore not to supply foreign exchange funds to OBOR projects, but to herald the arrival of China on the global financial stage and to act as the foundation for its global financial diplomacy.

   The land based infrastructure (road, rail, pipelines, digital backbone) aims to connect China to all parts of the Eurasian continent and to the Seas & Oceans surrounding Asia. The countries that such infrastructure passes through (rail, road, pipeline, fiber optic cables) or is located in (port, airport, industrial estate) have to provide the land on which it is built. They may also have to take on debt to pay for part of the real/full cost of this infrastructure. It is uncertain whether the economic benefits they will receive will exceed the costs they incur in terms of land, debts to China etc. I know an economic expert who has been hired by a Central Asian country to evaluate the benefits of a China proposed rail line that will cross its territory, and he was hard put to think of the benefits to this country which may become feasible (e.g. new exports). OBOR countries have to be extremely careful in evaluating the benefits and costs to them of any infrastructure built by China. The cost of permanently transferring land to Chinese Companies and/or taking on debt on behalf of projects, could prove very onerous to host countries in the medium-long term. 

      If the infrastructure is genuinely economic & not strategic, every country in the World should be able to use it once built, as this improves its economic viability, given sunk cost. So third countries, including India, have nothing additional to gain from "joining" the OBOR which will be built by Chinese Construction/ infrastructure companies. All Commercial  companies, including Indian ones, have the option of using the infrastructure (roads, railway, ports, airports, industrial estates) if it reduces costs and improves profitability.

     The AIIB is unlikely to be the primary source of funding for the OBOR, which from available numbers, requires funds of an order way beyond the capacity of the AIIB. As the bulk of financing will be domestic currency financing needed by Chinese construction companies, all that the AIIB can do is to provide the fraction of funds needed in the form of foreign exchange. More importantly, the AIIB is(in my view), needed to provide an international stamp of respectability to OBOR projects. This is suggested among other things, by the timing of the announcement of AIIB so soon after the formation of the New Development Bank (NDB) also referred to as the BRICS bank. The agreement to form the NDB was signed in Brazil in July 2014, after years of discussion.[v] China signed an MOU with 24 countries in October 2014 for the formation of the AIIB, five months after the unveiling of the new silk road and three months after the agreement to form the NDB.[vi]

    A Chinese scholar was recently asked about his estimate of the economic risks and returns to China of OBOR projects. His answer as reported without attribution, was that he didn't expect repayment of 80% of loans to CPEC projects, while repayment on other OBOR project loans would be between 30% and 50%. This implies, (a) That the rate of return on 80% of CPE projects and 60 to 70% is negative. It is not too far-fetched to assume that the rest of the benefits to China would be non-economic, i.e. Diplomatic and Strategic. Even in the projects with a positive rate of return, the economic and social return to the host country, accounting for the contribution of land, oil/mineral resources and natural resources like harbours & dam sites, is likely to be negative. 

DIPLOMATIC Aspects

  The OBOR is however, much more than a connectivity cum economic  program, it is also a comprehensive diplomatic initiative of a rising China.  It is a an instrument of China's diplomatic objective of ensuring that Asia and the World recognize China as a Great Power.  According to the Virmani(2004) Index of Power Potential (VIPP), China became a "potential great power" about  seven years ago, with its economic power exceeding 25% of that of the USA.^[vii]  Its relative economic power has grown rapidly since then to reach 42% in 2015, as per this index VIPP.  The OROP is viewed by the party leadership as an umbrella program for interaction with every country in Asia and the surrounding Seas.

The diplomatic initiative can be seen at three levels: Intellectual, Political and Financial:

(1) Intellectual: OBOR provides a framework for interaction with Academics, Think Tanks and Media, interested in economic development, infrastructure investment and trade & economic relations. This can facilitate movement in both directions; Chinese financed visits of foreign interlocutors to Chinese institutions and invitations for Chinese academics to these countries.

(2) Political: OBOR provides a framework for interaction with the political establishment, including government ministers, of each country. As in the case with intellectuals and academics, the Chinese can facilitate the visits of foreign politicians to China for the purpose of discussing OBOR. It provides a very useful cover for Chinese experts to explain their national position on every issue, including the South China Sea, Japan and USA.

(3) Financial: Every government minister is looking for funds to relieve budget constraints and finance pet projects. OBOR provides a framework for Chinese officials (Party, Govt) concerned with Chinese economy to interact with their counterparts in potential host countries, on their projects, programs and economic development objectives. At some stage it also involves the highest political authorities such as the Finance Minister and the Prime Minister/President of the country, allowing China's views on any subject of their choosing to be heard respectfully.

    Announcements of large financial projects and Programs attract widespread attention of all segments of society, even without any hard economic & financial analysis to determine viability. The personal contacts built during discussions can also be used to finance individual pro-China leaders, politicians & others, as allegedly happened in some S E Asian countries.

STRATEGIC Aspects

   The general strategic objective of OBOR is to  increase China's influence in the countries covered, to reduce US influence in these countries, and to pre-empt any potential increase in influence of US or its allies (existing or future). More concretely, the goal is to establish a strategic presence in these countries, including through sale of military equipment.  The strategic dimension of OBOR has two clear components. The continental and the maritime:

(1) Continental: This takes the name of the old silk road's disparate tracks across Central Asia, and applies the name to a "Hub and Spoke"  system of highways and railways radiating from China at its Center or Hub.  Given that oil pipelines and fiber optic info-ways did not exist at the time of the silk road, this is obviously a modern and valid add-on to traditional highways.  Given China's dependence on imported energy, the oil and gas pipelines are particularly important for diversifying both sources and supply routes for energy. The immediate strategic objectives are, (a) To  secure Central Asian and other neighboring Islamic States (Pakistan, Afghanistan, Iran)  from becoming a base for Xinjiang Liberation Movements, and (b) A revival of the old "Great Game", to develop land routes from continental Asia (China) to the Indian Ocean (through the Bay of Bengal, Arabian Sea and Gulf of Iran).

(2) Maritime: As "silk" is associated with China and the "Silk road" with connectivity, the Maritime dimension has disingenuously been called "Maritime Silk Road".^[viii] The "maritime silk road", clearly represents an evolution of what many called the "String of Pearls strategy".  All analysts writing on the "String of Pearls" agreed, that what had been done and planned so far was primarily economic.  However, those who were most suspicious about the "String of Pearls" warned that it was not merely possible but likely that these Pearls would be transformed into strategic bases, once the economic part was developed. The "Maritime Silk road" concept and the new security strategy[ix] has brought this potential development right into the present.  The strategic maritime dimension of OBOR is to develop a string of logistics basis in the Indian Ocean region, with likely conversion in future, of a few of them into naval bases. From China's perspective, the most desirable geographical locations for naval bases are those at the intersection of the "Maritime silk road" and the "New silk road" i.e.  those Ports that can be connected by overland route to China.[x]

CONCLUSION

  The post World War II, Marshall Plan was explicitly designed to help the revival of devastated European allies and to complement the makeover of Germany in its own image. This paid good social, economic and diplomatic dividends to the USA. However it was complemented by creation of NATO & other military blocks explicitly designed for Strategic purpose. Eventually each complemented the other, even though they may not initially have been part of an integrated economic, diplomatic and national security strategy.[xi]

   OBOR is presented to the world by China, as an infrastructure & economic development program. It is in reality an umbrella for a comprehensive but evolving, Economic, Diplomatic & Security strategy.[xii] It is part of a "Middle Kingdom Doctrine" (authors characterization) that seeks to make China the Central power in Asia: A (soon to become) Super Power that dominates Asia and its surrounding Seas and Oceans & exercises varying degrees of "suzerainty" over peripheral areas (including less well off parts of East Europe).[xiii] One strategic implication of this doctrine is to reduce and eventually eliminate US strategic power and influence in Asia and the surrounding seas.
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A version of this article appeared in the Salute Magazine, July-August 2016:  http://www.salute.co.in/one-belt-one-road-obor-economic-diplomatic-and-strategic-dimensions/

Footnotes:-

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[i]  http://news.xinhuanet.com/english/china/2015-03/28/c_134105858.htm .  In May 2015, we heard about it personally from Chinese scholars, one of who frankly admitted that even scholars like him were not aware of it a 3-4 months earlier, when they were asked to start work on fleshing out the concept of OBOR. 

[ii]  http://www.unescap.org/our-work/transport/asian-highway, http://www.unescap.org/our-work/transport/trans-asian-railway, https://en.wikipedia.org/wiki/Asian_Highway_Network ,  https://en.wikipedia.org/wiki/Trans-Asian_Railway

[iii] The new silk road was unveiled in May 2014 (not in 2013 as now claimed by some: A tentative mention of an idea by a leader is very different from a reasonably worked out Government initiative). https://www.google.co.in/url?sa=t&rct=j&q=&esrc=s&source=web&cd=2&cad=rja&uact=8&ved=0ahUKEwjd37PR3ODMAhVEFZQKHadmDfcQFgghMAE&url=http%3A%2F%2Fthediplomat.com%2F2014%2F11%2Fthe-new-silk-road-chinas-marshall-plan%2F&usg=AFQjCNESJKb91Dup4gkiXit38EjW7eNmEA http://thediplomat.com/2014/05/chinas-new-silk-road-vision-revealed/

[iv]  https://en.wikipedia.org/wiki/String_of_Pearls_%28Indian_Ocean%29 , http://thediplomat.com/2015/12/is-chinas-maritime-silk-road-a-military-strategy/, http://csis.org/files/publication/140624_issuesinsights_vol14no7.pdf

[v] I was personally involved in some of these discussions, as Executive director at the IMF, Washington DC, from November 2009 to October 2012, charged with overseeing financial discussions among the BRICS. During this period there was no hint that an AIIB may be formed at the initiative of China.

[vi] https://www.google.co.in/url?sa=t&rct=j&q=&esrc=s&source=web&cd=2  

[vii] See references at https://sites.google.com/site/drarvindvirmani/india-great-power .

[viii] The inclusion of "road" in the designation of a maritime initiative is puzzling to all but those who think every word that CCP leaders use is a nugget of philosophy.

[ix] https://muse.jhu.edu/article/611561/pdf , http://www.chinadaily.com.cn/china/2015-05/26/content_20820628.htm ;

[x] This explains China's keenness to develop ports in Pakistan, Bangladesh and Myanmar. But it also suggests that China may be willing to complement the development of a naval base at Gwadar, Pakistan (CPEC), by participating in development of connectivity to Chabhar port in Iran.

[xi] Chinese Admiral Sun apparently admitted that OBOR has strategic dimension at Singapore Strategic Dialogue 2016: https://twitter.com/d_jaishankar/status/739277268237746177

[xii] Chinese scholars indicated to us (about 20 people), all of them have been instructed to work on OBOR & come up with something (presumably every think tank" in China),

[xiii] According to the VIPP index, China will become a "potential Super Power" at the end of this decade.

Growth, Inflation and Monetary Policy: 2016-17

Global Outlook for 2016

US GDP growth in 2% to 2.5% range with greater likelihood of being at the lower end of the range.  End year Inflation likely to remain below FED target of 2%. Consequently FED unlikely to raise rates more than once or twice during year. EU & Japan recovery very slow.

China real growth already below 6%, likely to fall below 4.5% in about 3 years.  Negative effects on global economy are already in process as the vaunted market reforms are likely to remain on paper for political economy reasons (maintaining monopoly of CCPs political power). Official GDP growth rate likely to be propped up by further credit expansion, but this time channeled formally through government budget account. The eventual bursting of this latest bubble will ensure that actual growth falls below 4.5%, even if official growth is maintained at 5.5% to 6.5% for 3-5 years.  Thus China will continue to export deflation to the World with continuing negative effects on the Globalised part of Indian corporate sector (e.g. metals & mining). However, because of the reintroduction of capital and other economic controls, and tightening of political and media controls, public surprises for global economic are likely to be moderated.

Outlook for Oil: Oil prices are likely to remain range bound in $30 to $45 range, with annual average growth for 2016 over 2015 being in single digit.

Implication for India: Recovery in the Globalized Corporate sector, namely in its Investment, Profits and Output growth will be slow. Deflationary pressure on Indian prices will continue but on a more moderate scale than in 2015.

Indian Economy

Review of 2015-16

    In the beginning of 2014-15 and 2015-16 we forecast an acceleration in GDP growth of 0.5% in each case. The actual results have been an average acceleration of about 0.25% point (assuming the NAS projection for 2015-16 comes true).  In September 2015, we predicted that end year (ie March 2016) CPI inflation would be between 4.5% and 5% with 60% probability, I also put a 20% probability of inflation between  5% to 5.5% and 20% probability of 4% to 4.5%. One of the investment banks has estimated that March 2016 inflation will be 5%, within the predicted range, but 0.25% above the predicted mean of 4.75%.

    Despite an average GDP growth rate of around 7.6% in constant prices, and nominal of 8.6% in 2015-16 (CSO projection) two sectors have seen noticeably slower growth. These are agriculture-rural and listed companies. The former is clearly due to the rare occurrence of two consecutive droughts. The latter is related to the global deflationary impulses (discussed above) and the sharp decline in nominal GDP growth over the last 5 years. The former also has a (greater) effect on the latter through what one has called "quality downshifting" (movement down the quality ladder for consumer goods) as  people buy cheaper lower quality goods to reduce drawdown of savings.

Prospects for 2016-17

      There are three domestic developments that will affect the economy during 2016-17. The most important is a normal monsoon after two consecutive drought years. To my knowledge there is no record of three consecutive drought years. The last time there were two consecutive droughts in late 1980s the following year of normal monsoon saw an agricultural growth of about 19%. My rough estimates suggest that agriculture growth in 2016-17 is likely to be around 8%-9%.   This will correct one major source of unbalanced growth, have a positive effect on corporate demand and profits and on animal spirits as reflected for instance in the stock markets.

   Corporate sector growth in the first half of the year, before the good harvest comes in, will be more directly affected by the increased government infrastructure orders that have been set in motion in the 2015-16 budget. These will start getting translated into actual expenditures and investment in 2016-17.

   The third factor will be the fall in real interest rates from the highs they had risen to during 2015-16. This will have a positive impact on consumer durables, housing and construction industries and on consumer durables demand generally. 

  The sector spread of growth will therefore definitely improve in 2016-17. Depending on the degree to which each of these three factors play out, we project an acceleration in GDP growth, of between  0.2% & 0.5% point  above the 2016-17 level.  As of February, CSO estimated 2015-16 growth rate of 7.6%. If this growth rate holds, GDP growth in 2016-17 will be in the 7.8% to 8.1% range. If 2015-16 growth is revised down, one would expect a corresponding adjustment in 2016-17 growth.

   Given these domestic and international developments, my probabilistic forecast for end year CPI inflation (March 2017) is as follows: 70% probability of inflation rate of 4% to 5%, 20% probability of inflation rate below 4% (the RBI target for 2018) and 10% probability of inflation rate above 5%. This forecasts incorporates a repo rate reduction of 75 basis points within the first quarter of 2016-17.

Monetary Policy

 Recommendation (30/3/16)

     I recommend a repo rate cut of 50 BPS in the April policy, followed by a rate cut of 25 BPS in the June policy. The primary reason for dividing up the recommended rate cut of 75 BPS is the uncertainty in the minds of many economists about whether there will be a normal monsoon.  One is fairly confident,  based on historical patterns, that there will be a normal monsoon this year, but by their very nature the  "black swan" of a third consecutive drought can't be ruled out.  This rate cut is also incorporated in the  inflation and growth forecasts given earlier.

Liquidity & Imperfect Markets

     Ever since the start of the Indian debate on "Inflation Targeting" a decade ago, one has pointed to the danger of assuming that Indian financial markets work like the highly integrated and developed US financial market. Indian financial markets were highly fragmented and underdeveloped in 1991 when economic and financial reforms started. Since then financial and other reforms have resulted in the development of markets for consumer finance and many other segments. However, they still nowhere near the level of the US financial market.  One monetary policy consequence of this difference, that one had pointed to, was that old fashioned monetary targets like reserve money, M1 and M3 growth were not as irrelevant/useless as they were considered to be in developed countries.  Another consequence of imperfect markets was and is the imperfect/inadequate transmission of repo rate signals into interest rates charged by banks as well as those prevailing in the financial markets.

   The increased focus on "transmission" during the last year and the returning focus on "long term liquidity" in the RBIs monetary policy, is an implicit recognition of the way in which Indian financial markets differ from developed ones. Thus it is a very welcome development.

Conclusion

  Economic growth will likely accelerate by 0.2% to 0.5% point in 2016-17 over the growth rate for 2015-16, and this growth will be much more evenly distributed over sectors and areas. If the CSO estimate of growth for 7.6% in 2015-16 is correct, GDP growth in 2016-17 is projected to be between  7.8% and 8.1%.  Sectors such as agriculture, construction and corporate sectors that have been below par will pick up significantly. The top end of the range is however likely only if monsoon is well distributed and timely and the monetary-fiscal policy mix continues to improve. Passage of key legislation such as Bankruptcy law and GST would also reduce risks to the economy and increase the probability of 8% growth.

  CPI Inflation will decline further from a likely 5% in March 2016 to an expected value of about 4.4% in March 2017, with a 20% probability of 4% or  lower, which is the RBI target for March 2018. Given decelerating inflation, nominal GDP growth is unlikely to recover from very sharply from the CSO estimated 8.6% for 2016-17. Thus one should expect nominal sales and profits to close the gap with real GDP growth rates that has happened since the sharp decline in inflation.