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.

-----------------

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/  .

---

[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

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.