Deciphering India's GDP math

India released its provisional estimates of the annual national income for 2016-17 and quarterly estimates of the Gross Domestic Product (GDP) for the fourth quarter of 2016-17 on May 31: the data suggests that the Indian economy is actually in crisis mode. Government spending and surging iron ore production in the year saved the day—or else the growth in GDP for 2016-17 would have been far more anaemic. Government final consumption expenditure rose more than 25% in nominal terms and by more than 20% in real terms in 2016-17. Iron ore production in 2016-17 was around 200 million metric tonnes. That is why the mining and quarrying sector Gross Value Added (GVA) rose by 33% (year on year) in the fourth quarter of 2016-17.

The economic slowdown was in the works since 2016–well before the government’s demonetisation exercise in November–because private capital formation has been missing in action. At current prices, the ratio of Gross Capital Formation to GDP sank to a new low of 25.5% in the fourth quarter of 2016-17. This must serve as a wakeup call to the policy makers in Delhi and Mumbai.

Gross Fixed Capital Formation/GDP ratio of 25.5% is inconsistent with India’s aspirations to be a large and influential economy in the world. Clearly, the time lost in addressing the banking sector’s woes has extracted a hefty price in terms of economic dynamism. Eventually, the blame for the stasis has to fall on the owner and the regulator as the biggest share of non-performing loans is with the majority of government-owned banks.

To a degree, foreign direct investment (FDI) equity inflows into India–estimated at around $43.5 billion for 2016-17 and at $40 billion for 2015-16–have helped cushion the investment shortfall. But India’s investment/GDP ratio must be substantially higher than 25% for it to achieve economic growth of 8% or more. Therefore, capital formation growth is likely to be taking place at 15% (approximately $300 billion) every year if nominal GDP growth is rising at about 10% (about $200 billion). Therefore, FDI inflows are only a fraction of the overall investment that is needed to lift and sustain economic growth. Further, India’s incremental capital-output ratio must be rather high–around 5.0-6.0–because the number and volume of stalled projects have not declined. That puts the trend growth rate of the economy at around 5% to 6%.

In a way, India’s Central Statistical Organisation has done a major disservice to the policy discourse in the country. Printing growth rates of 7% or more has lulled most policy makers into a sense of complacency about the underlying health of the economy. It has not been possible to reconcile this number with private sector investment rates, credit growth, electricity demand nor production in infrastructure industries. Bank credit growth to industry–micro & small, medium and large enterprises–has declined over the years.

As of March 2017, the latest month for which data is available from the Reserve Bank of India, annual growth rates are now -1.9% for all industries and -0.4%, -8.7% and -1.8% for micro & small, medium and large industries respectively. Credit to medium industrial units has been contracting for two years and that for micro & small units for over 15 months. These firms do not have access to capital markets the way the large ones do.

This is one of the obvious explanations for Gross Fixed Capital Formation (at current prices) to drop from 34.3% of GDP in 2011-12 to 27.1% in 2016-17. Five of the eight industries designated as core industries showed contraction (y/y) in production in February 2017. The exceptions were coal, steel and electricity. Overall production growth in the eight core industries was a mere 1.0% (y/y) in February 2017.

The question of whether the demonetisation exercise added to Indian macro-economic woes has now been answered. It has. Worse, it is not over yet.

The GVA of Finance, Real Estate and Professional Services tells us that it will take quite a few quarters for it to reach the level last seen in the second quarter of 2016-17. It dropped from Rs 8.56 trillion in the second quarter of the fiscal year 2016-17 to Rs 6.218 trillion in the third quarter (when demonetisation occurred) before recovering slightly to Rs 6.431 trillion in the fourth quarter. If financial and real estate services are recovering only slowly from the slump in the third quarter of 2016-17, we should expect the construction sector to continue to contract in the quarters ahead. GVA in the construction sector declined to Rs 2.589 trillion in the fourth quarter of 2016-17 from Rs 2.653 trillion in the third quarter. All the figures are at current prices and India’s fiscal year runs from April to March.

The Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) must be feeling embarrassed about adopting tough language on inflation risks in its meetings in February and April. The inflation rate slowed down substantially subsequently, which the MPC acknowledged at its monetary policy meeting on June 6-7. It has marked down the forecast for inflation for the first half of 2016-17 (April to September) to a range of 2% to 3.5% from the previous 4.5% and to a range of 3.5% to 4.5% against a point forecast of 5% in the last review. Despite this substantial downward revision of its own inflation forecasts, it left the repo rate unchanged at 6.25%.

The efficacy of interest rate cuts in reviving capital expenditure in the real economy in a balance sheet- constrained environment is always dubious. But, India’s real rate is not negative as it was in advanced countries during the last eight years. Ultra-low or negative rates do not help revive investment spending, which is a well-documented fact. India’s real rate of interest–based on realised consumer price index growth–is quite positive and there is room for some reduction.

The implementation of the Goods and Services Tax (GST) is, doubtless, a risk factor for inflation. Globally, the implementation of GST has provided an excuse for prices to be revised to a higher level. However, with the government threatening fines and imprisonment—which did not work in Malaysia– price increases on the back of GST implementation could be muted.

On balance, after the release of the GDP data, the risk of being wrong with a rate cut appeared lower than the risk of being wrong with an unchanged stance. The MPC saw it differently and did not cut interest rates. They may have left the door open for this for the next meeting in August. From a growth perspective, one hopes that the delay does not turn out to be costly.

The government, for its part, must introspect. The budget for 2017-18 offered an important opportunity for it to remove economic uncertainty and infuse dynamism, especially in the aftermath of the demonetisation exercise, but it missed it. Promised corporate tax cuts were postponed. Official statistics, painting a picture of robust economic growth of over 7%, played their part in inducing a sense of policy complacency.

The government must step out of the hologram and accept the reality of the economy being unhealthy. The privatisation of the government-owned Air India may not bring in substantial revenue for the government, but will send out an important signal: that it is no longer ‘business as usual’ and that there are no more ‘sacred cows’ in the public sector. In the next 60 days, the government must work towards one or two high-profile privatisations and resolution of a few prominent debt defaults in the banking system, backed up by the central bank’s rate cut. If the capital formation rate of 25.5% did not wake up the RBI and government, nothing else will.

Dr. V. Anantha-Nageswaran is Adjunct Senior Fellow, Geoeconomics Studies, at Gateway House.

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