All that glitters in 7.4% GDP is not growth; here's why govt should be worried

The 7.4% GDP growth for Q2 2015-16 may give the impression that the economy is on recovery track considering the growth in the previous quarter was 7.1 percent. With Indian GDP growth beating China and inflation broadly under control, one may tend to agree with NITI Aayog Vice-Chairman Arvind Panagariya that the Indian GDP will reach 8% in FY15-16. [caption id=“attachment_2527980” align=“alignleft” width=“380”]  Reuters[/caption] But the truth is it is not all that rosy as it is made out to be. If the disturbing trend which emerged in the first quarter (April-June 2015-16) and strengthened further in July-September continues, then the real GDP of India may be close to 8% but ironically it will go on to imply that the country has moved further away from the recovery path. In a previous article, the author highlighted that nominal GDP (or GDP at current prices) is reflecting the economy which we face in our daily lives. The corporate balance sheets and profit and loss statements are nominal to the extent that they are not adjusted for system-wide inflation. The nominal GDP when adjusted for system-wide inflation (GDP deflator) gives the real GDP growth measures. When Panagariya says 8%, he means 8% real GDP growth. Of course, a few economists ventured to predict the nominal GDP. After the data was released, most media reports said the 7.4 percent growth is broadly in line with consensus estimates. It would be good to know whether any of the forecasters expected a Q2 nominal GDP growth of 6%. In fact, the sequential fall in quarterly nominal GDP growth (from 8.8 percent in April-June) in last two quarters suggests that the nominal GDP growth in the first half of 2015-16 is the weakest in more than a decade. These are not exactly the signs of an economy on recovery track and the moribund corporate results bear testimony to that. The GDP deflator for the second quarter was a negative 1.4% (GVA deflator was negative 2.2 for the same period). This actually behaved as a GDP inflator, to the extent that the real GDP was inflated above the nominal GDP. This point has also been highlighted in the previous article. It gives an impression that inflation is coming under control. However, the GDP deflator, as has been the case in the past, tends to reflect the wholesale price index (WPI) more than consumer price index(CPI). The negative reading of WPI suggests a sharp disinflation in the industrial activity. However, it may be argued that global correction in commodity prices is just one of the drivers of the negative WPI. Demand destruction in the industrial activity, reflective of low capacity utilisation and anaemic private investment activity, may also have a role in generating negative WPI. When most market experts forecasted a GDP gowth of 7-8 percent for this year and set a Sensex target of 28,000 to 31,000 by March 2016, they possibly had in their mind a nominal GDP growth rate of 11-12 percent and a commensurate corporate performance. However, the GDP deflator in April-June was 1.8 percent, while in the second quarter it fell to -1.4%. If this trend – a rarity for emerging markets, particularly India – continues, then we may have a nominal GDP of say 5 percent and a GDP deflator of -3.0 percent. This will give us the magic 8 percent GDP number, only it will mean that corporate performance will deteriorate further and investment activity will hit further lows. The immediate casualty of this low nominal GDP growth will be the government’s fiscal mathematics. The recent budget, while estimating a fiscal deficit of below 4 percent in 2015-16 assumed a nominal GDP growth of 11-12%. Clearly, if the rest of the year continues to exhibit nominal GDP growth number in the range of 6-8 percent, there is a possibility that the targeted reduction of fiscal deficit may become challenging. The possible solution may actually be a very sharp cut in interest rate (which should also be immediately transmitted by the banking system) to the extent of 150-200 basis points. But given the spectre of a US interest rate hike, the RBI may not like to take this step and trigger another bout of rupee sell-off. At any rate the rupee has exhibited a weakening bias in the last couple of weeks. The RBI can definitely take the call for sharp interest rate cut as and when the uncertainty regarding the US Fed’s rate hike is settled. Until such time, the RBI may not be able to help beyond a 25-50 basis point rate cut. Thus the 7.4 percent growth with negative deflator raises more questions on India’s economic trajectory than it answers. The author is a visiting faculty at IIM Calcutta and a financial services professional.