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Poor GDP print overturns the harvardian rebuke

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Mr.Dhananjay Sinha

Head of Research, Economist & Strategist

06 Jun 2017

The Harvardian diatribe over the impact of the demonetization misadventure may have deafened amid the din of incremental other events like UP election outcome, GST, Kashmir issue and bovine politics etc. But the disappointing GDP release for Q4FY17 has given a body blow to mockery the government meted out to independent experts who had prognosticated grim impact of demonetization. Tall claims of delivering improved eco system ranged from fighting black money, paralyzing terrorism, digitization, recapitalizing banks from demonetization dividend etc, now appear completely specious.

The provisional reading of 7.1% real GDP growth for Q3FY17 had earlier prompted official denial of any significant impact of demonetization, but the scaling down of revised growth to 7.0% in Dec’17 quarter and further to 6.1% in Q4 established that the impact was indeed unfavorable. The Gross Value Added (GVA) measure of GDP, which represents the erstwhile production side, shows a steep decline to 5.6% vs 8.7% a year back, or nearly 210bp. [On the earlier GDP series (base year 2004-2005), which is closer to the ground reality than the prevailing 2011-2012 series, the real GDP growth for Q4 would be even lower at just 4%!]

Prior to demonetization (Jul’16), the professional forecast for GDP growth for FY17 was projected at 7.5-7.6% and the official estimates were also at similar level. However, after the announcement of demonetization official projections were scaled down to 7.1%. The basis of earlier optimism for FY17 were factors such as normal monsoon, festive demand, larger government spending, global recovery, and better corporate performance among other factors. But the demonetization shock stymied the build-up of momentum and caused significant economic loss. Assuming that the base case in a no-demonitisation scenario was indeed 7.5%, the loss of real GDP could be around Rs 1tn or ~100bps. 

Here the caveat is that Q4FY17 number is still provisional and captures the impact on the informal sector only partially. The final cut back in real GDP could be larger around 200bp as per our estimates. The lower growth in the newly recast industrial production (IIP) data, which incorporate some informal components now, is an indication of the possible impact once other components of GDP also incorporate sector specific informal elements over time.

One factor worth point out here. The formal component of manufacturing sector captures the financial results of non-finance companies. But Q4FY17 corporate result season is still underway and aggregate numbers till now show a 3.5-4% YoY decline in profit, implying that the formal component in manufacturing sector GVA may be overstated. Hence, in all probability manufacturing sector real GVA growth, which decelerated to 5.3% from 10.3% a year back, is likely to be revised further down.

Beyond just the headline numbers, the details reflect the grim reality. The construction sector, which deploys highest number of labors after agriculture, shrunk by 3.7% in Q4FY17, the slowest clip since 1998. The severe impact that the demonetization shock on banking, financial and business services, reflects in the real GVA growth, declining to a 20 year low of 2.2%. The only supporting component in Q4 GDP data is yet again higher government spending, which has kept up the pace of growth for government services at a staggering 32%.

The investment activities has also been impacted with real fixed investment declining by 2% YoY in Q4FY17 and fixed investment/GDP ratio declined to 25.5%, a 13 year low and where the average investment rate remained range bound since 1997. Average fixed investment rate for full year FY17 stood at 27%, substantially  lower than 36% in FY08 and past three years average of 29%. Clearly, while the government boasts of lower current account deficit and higher foreign direct investments as its achievement, these have not been enough to resuscitate private investment activities. Hence, expectations of private investment revival through better governance and other initiatives like “make in India” has yet not materialized.

Sustained decline in investment rate, especially after FY13 when it was at 33.4%, has been a cause of declining employment generation in recent years. But as other indicators such as impact of construction activities, informal services and MNREGA data suggest, the demonetization experiment may have aggravated the unemployment problem even more.

Agriculture sector GVA is estimated to have grown impressively at 5.2% in Q4FY17 and an average of 6% during the second half of FY17. But isn’t that inconsistent with demands for farm loan waiver getting wider and deeper post demonetization? The answer lies in the fact that the farm sector was most severely impacted due to decline in realization for agri produce as a fallout of demonetization, especially perishable items. Hence, nominal growth for the agriculture sector declined to 7.9% in Q4FY17 and an average of 8.4% in second half of FY17 vs 10% in the first half FY17. This is lowest growth since FY2006.

A point on nominal GDP numbers. Nominal GDP growth for Q4FY17 is estimated at 12.5% compared to 10.4% in the previous quarter and highest since 2013. This may give a false impression of better growth conditions and that the slowdown in real GDP to 6.1% is only on account of higher inflation. But the estimated GDP deflator based inflation of 6.4% (12.5%-6.1%) is higher than both average WPI and CPI inflation at 5.0% and 3.6% respectively. This overstatement in GDP deflator leads us to an eventual possibility of ~200bp downward revision of nominal GDP growth as well to around 10.5%.

Shifting of cash transactions into the fold of banking or formal transactions was one of the goals that the government wanted to achieve. However, two facts distinctly contend that claim.

One, replenishment of currency post demonetization has been quicker than expected and currently is 83% of the Rs 18tn currency stock prior to demonetization announcement on Nov 8th 2016; at the lowest level it had declined by 50% by Jan 6th 2017. Thus currency supply is quickly being absorbed in the system, implying that demonetization has failed to lower the currency holding propensity in the economy or shifted the economy towards cashless transactions.

Second, the recovery in bank credit growth, which embodies banking transactions, has been very gradual. It has declined from 10% prior to demonetization, when it was showing signs of recovery, to a 60 year low of 3.7% in Feb’17. It has recovered to 6.4%, which is still quite modest.

Summing up, latest GDP numbers and various leading indicators suggest that dismissing the impact of demonetization was clearly misleading. Far from justifying narcissism, it will be pertinent for government policies to address the lingering issues of falling private investments, slackening employment, farm sector distress and faltering banking system. Gaining cyclical upturn in developed economies, especially in the US and Europe bodes well for emerging economies, including India. Measures like demonetization can only hinder such positive spillovers and enhance the risk from things like protectionism. The risk is that electoral compulsions ahead of the 2019 general elections, may intensify populist agenda at the cost of growth enduring policy responses.