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Did Q3 GDP print camouflage demonetization impact?

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Mr.Dhananjay Sinha

Head of Research and strategist

01 Mar 2017

The enigma around the GDP growth numbers has compounded as it understates the demonetization impact. Eliminating the dissonance created by large revisions, the nominal GDP growth in Q3 may have been impacted by 240bp and 320bp on YoY and sequential basis respectively

The 7.0% real GDP growth print for Q3FY17 released by the CSO yesterday gives an impression that the demonetization shock did not have any impact on the economy. It has also prompted many to conclude that the earlier grim assessment by many analysts may have been an over-reaction, with a critical bias on the entire demonetization exercise. This 7% real growth is only modestly lower than 7.4% in Q2 and somewhat higher than 6.9% a year back. Growth in real Gross Value Added (GVA), which now represents the activity based GDP, grew at 6.7% in Q3 compared to 6.7% in Q2 and 8.2% a year back.

While the new GDP series (base year 2011-12) has been an enigma since its inception, as it estimates growth numbers much higher than indicated by most industry level leading indicators, the Q3 release has compounded the puzzle even more. For instance, how does the economy grow at 12% and 7% in nominal and real terms respectively, when the lending growth of banks has declined to a 60-year low of 5%. Interestingly, the economy has also grown at this rapid pace with sustained absence of investments for past 6-7 years, slowing trade, decelerating IT sector, real estate construction in limbo for more than 3 years and without much job creation. Likewise, manufacturing GVA has expanded by 10.6% in FY17YTD when manufacturing production growth has been contracting and sector is facing considerably weak pricing power.

Economic Survey 2016-17 provides some clue on the impact of demonetization. For one, the true extent of cash reduction due to demonetization was much lower than commonly perceived. Second, the shortfall in currency supply narrowed rapidly in Dec and thereafter. Presumably hence, the impact of the shock was much lesser than generally estimated.

The Survey goes on to substantiate that Agri sector has not been impacted much as the sowing area during the rabi season expanded in excess of 7% YoY. Further, barring the real estate sector and two-wheelers, most other indicators such as excise duty collection, passenger car sales, credit growth normalized for other funding sources etc, did not show much imprint of demonetization. The survey concluded a broad range of impact of 25-100bp from its baseline FY17 nominal GDP projection of 11.25% and 25-50bp decline in real GDP from a baseline of 7%. 

Based on the data available till Economic Survey publication (ie prior to Q3 GDP release), its projected impact would have resulted in nominal GDP growth decelerating in H2FY17 to 10.7% (with 25bp impact) or 9.3% (100bp impact) compared to its baseline projection (ie if demonetization did not happen) of 11.2% for H2FY17.

Compared to these projections, CSO’s Q3 GDP release estimating nominal GDP growth of 10.7% and advance estimate of 11.5% for entire FY17 are far too strong. They imply H2 growth of 11.7%, much higher than the best and worse-case H2 scenarios of 10.7% and 9.3% projected by the Economic Survey. Even the 10.7% estimated for Q3 appears optimistic given the assumption that the impact of demonetization was strongest during Nov-Dec 2016. The implied growth for Q4 based in CSO’s latest advance estimates now stands at 12.7%, ie highest since Dec 2013. Thus, against the backdrop of the sensitivity analysis done by the Economic Survey, which in my view is somewhat benign, the CSO’s advance estimates give an impression that the impact of demonetization has been a puny little, and would be limited just to Q3 performance.

But that is just a statistical jugglery.

A lot gets revealed if we closely look at the significant revisions of past data in CSO’s estimates. The downwardly revised Q3FY16 nominal GDP growth of 8.7% vs 9.1% earlier, has created a beneficial base for Q3FY17. On unchanged base, Q3FY17 nominal GDP growth would have been at 9.7% instead of the reported 10.7%. Hence, on an unchanged base, the deceleration in Q3FY17 has been a massive 240bp compared to an unrevised estimate of 12.1% for Q2FY17 (Sep 2017 quarter).

Secondly, the reported 2.6% sequential growth for Q3FY17, over the previous quarter (Q2FY17) is significantly lesser than the average seasonal rise of 5-6% during Q3. Higher government spending, better monsoon in FY17 and strong festive demand would have implied a base case sequential rise of at least 6%. Hence, on a sequential basis the reported 2.6% QoQ growth is a slippage of at least 320bp implying loss of around Rs1.2tn in nominal GDP, largely attributable to the demonetization shock.

Hence, assuming GDP deflator for Q3FY17 at 3.2%, real GDP growth for Q3FY17 on unchanged base would have been at 6.4% compared to the reported 7.0% and Economic Survey’s base case of 7.4% (in absence of demonetization). The 60bp decline in GDP deflator from 3.8% in Q2FY17, despite continued rise in core inflation indicators also reflects the impact of demonetization on the horticulture sector (~55% of the Agri GDP), where the cash withdrawal contributed to a sharp decline in price realizations and loss of margin for the overall farm sector.

Beyond just the GDP numbers, it is likely that the informal sector may have been impacted more severely due to demonetization, as also acknowledged by the Economic Survey, and reflects in the sharp rise in demand for MNREGA jobs during Nov’16-Jan’17. This partly explains the massive 42% rise in allocation from Rs330bn in FY16 to Rs470bn revised estimate for FY17. Eventual allocation can be even higher as full impact of demonetization on MNREGA has not been incorporated in the Union Budget 2017-18 statements, in my view.

Eventually, relevance of the GDP numbers continues to remain challenged and the understatement of the demonetization impact compounds it further. Eliminating the dissonance created by large revisions, the nomiAdd Reportnal GDP growth may have been impacted by 240bp on year on year basis and 320bp on sequential basis. As the numbers for FY17 get further to incorporate informal sector components, the final numbers would indeed reflect the real impact of demonetisation. While the normalization of the demonetisation shock and cyclical global recovery bode well for FY18, it is likely that fiscal policies will continue allocating more towards rural and farm sector and job creation. As in earlier years, these imperatives will dilute the purported prudence of the Union and State government budgets.