Behind GDP bounce

It is now generally believed that economic growth has bottomed out. It reached a trough of 5.7 per cent in the first quarter of 2017-18, before rebounding mildly to 6.3 per cent in the second quarter. Is this a genuine recovery to a higher growth path? Is the business cycle turning? Is it a “dead cat bounce”, in which the force of deceleration was so strong that a reversal was inevitable before stabilisation at a new, much lower level of growth?

We won’t be sure for some time. But some points seem inarguable. First, it is clear that the effects of the two shocks of demonetisation and GST (goods and services tax) introduction are working their way through the system at different speeds. The immediate effect of demonetisation on measurable output is probably over. But the effects of the GST are still to play themselves out. The first quarter was depressed in particular because of the de-stocking of previously manufactured goods in advance of the GST’s introduction; the second quarter was elevated slightly by a re-stocking of depleted inventories. Meanwhile, there continue to be tweaks made to the GST structure, rules, and rates. Input credit payments are yet to be released in full, and the entire invoice matching process is yet to demonstrate its effectiveness or lack thereof. So we will need to watch at least two more quarters to try and figure out just what the GST’s first-order effect is. It’s hoped that second-order effects once the system is in place will be large and positive, in that the general equilibrium effect will lower costs and increase economic activity. But that is sometime in the future — and only if the second-order effects of this very sub-optimal form of the GST do in fact pan out as expected.

Second, a small degree of caution should accompany our interpretation of the latest GDP numbers. This is because the GST’s introduction has also impacted the way in which this data is measured. Usually growth in the trade sector is estimated from growth in indirect tax collections; given that Q2 was a post-GST quarter, the Q2-Q1 figure for indirect tax collections was not meaningful. So various shortcuts involving the petroleum sector, which has been kept outside the GST framework, were used instead. These shortcuts might be off-base, given that Q2 was a period in which oil prices finally began to rise. It is relevant to note here that a large proportion of the final growth number came from a 10 per cent year-on-year increase in the trade, hotels, and transport sector. Another odd aspect of the latest growth numbers was the apparent incompatibility between the decent activity shown in the construction figures and other estimates of demand in the cement sector. (At the margin, bans on pet coke and sand mining by various courts may have made a difference to cement demand from November onwards, but that does not explain the general contradiction.)

Third, evidence is mixed on the return of some demand in the economy. You could see a return of demand, if you’re looking for it, in the latest inflation numbers of 4.9 per cent for November. But growth in the index of industrial production is slowing; it was 2.2 per cent year-on-year in October as against 4.1 per cent in September. (Here, of course, the odd production patterns of the festive season may play some role.) Nor do the consumption and exports numbers in the GDP data look particularly promising. Private final consumption expenditure grew 6.5 per cent year-on-year in Q2 of 2017-18 as opposed to 7.9 per cent in the same quarter of 2016-17.

Illustration by Ajay Mohanty
Fourth, there continues to be no sign of a revival in private investment. It is true that gross fixed capital formation (GFCF) grew at 4.7 per cent in Q2. This is better than no growth. But it is worth noting that investment, as measured by GFCF, is in fact a lower proportion of output in Q2 than in Q1 — 28.9 as against 29.8 in the previous quarter. This is in fact the lowest proportion in the last four quarters. Nor is there any pickup in new investments captured by the Centre for Monitoring Indian Economy’s capital expenditure database. Just as new projects are at multi-year lows, stalled projects, particularly in manufacturing and power, are at multi-year highs.

It isn’t surprising therefore that there is a significant lack of consensus even among non-government sources as to when, for example, India will “return” to 7.5 per cent growth. Morgan Stanley expects below 6.5 per cent this year but 7.5 per cent next year, as does Nomura; whereas Standard Chartered suggests it will take “a few years to return to GDP growth levels of 7.5 per cent and above”. I think it is brave indeed to assume that 7.5 per cent or above is achievable, leave alone sustainable, without private investment adding at least a few more percentage points as a proportion of GDP. I simply can’t find grounds for optimism just yet.

There are, however, significant grounds for concern — if not about growth then about a suddenly more precarious fiscal situation. This was a major theme from many speakers at the annual Neemrana Conference this weekend. The GST has brought with it significant uncertainty about future revenue streams. In addition, while the Union government has worked to reduce its deficit, the state governments have moved in the opposite direction. The crowding-out effect of this fiscal pressure has not yet hit, but will be significant going forward. Both state and central paper has flooded the bond market, along with much quasi-public debt from issuers like the National Highways Authority of India. State power bonds under UDAY (Ujwal DISCOM Assurance Yojana) are already out; Rs 1.35 lakh worth of bank recapitalisation bonds have been announced. And the Reserve Bank has been sterilising its purchases of dollars with open market operations as well. The effect on yields has not yet fully materialised because of the large amount of post-demonetisation capital that has moved into mutual funds, which in turn have bought many of the quasi-public bonds. But it will materialise in large part sometime soon. Already India’s sovereign yield curve is at its steepest since 2011 — a big change in just six months. This comes at a time when banks are focused on cleaning up their balance sheets instead of extending further credit and so the corporate bond market is a major source of capital for the private sector we’re relying on to drive a recovery.

Overall, the picture is not rosy. India does not look like growing out of its problems, including high general government deficits. We are also moving into a general election cycle, with its associated pressures. It is hard to say anything optimistic about India’s macro indicators even for the medium term, when the twin shocks of demonetisation and GST should firmly be in the past.
Twitter: @mihirssharma