How does one gauge the state of the economy? Currently, there are various signals that we receive depending on a specific aspect of the economy which are not always in consonance with one another. While the CSO has told us that the GDP growth this year will be 7.4%, one is not too convinced as it does not match the other conditions. Is there any leading indicator that can be used for capturing the state of economy?
Normally, the stock index is supposed to be the best indicator and probably the most efficient one. It is useful insofar as investors are taking decisions based on how they perceive the economy and the path that it is following. Therefore, the news of the passage of the coal and mining Bills in the Rajya Sabha will get immediately taken in by the Sensex and Nifty, which reflect the sentiment too. As it is a real-time index, it actually takes in all the available information. Further, since such indices are forward-looking, they also take in future expectations. If the market believes that the economy will grow by 8% next year, then it gets embedded in the movement and in a way enters the foundation of all expectations. The stock index is efficient because it is being determined by myriad such sentiments being expressed with the magnitude of change dependent on the quantum of such expectations.
However, going by this logic, we would all have been proved incorrect as the sense has been quite ebullient this year, though the ground-level situation has been fairly nebulous. In fact, the argument that value added from manufacturing being higher than manufacturing output on account of better quality and hence better quality products entering the basket is not reassuring, as while it can hold for some goods—maybe more high-end cars being manufactured—it does not hold for most other goods.
One tool which can be used is household spending, but as this information too comes with a lag, a better indicator is growth in consumer goods. As our economy is still consumption driven with its share of 60% in GDP, it can be a useful proxy for this growth process. But in years when the government is a big spender, there can be a mismatch. But to the extent that consumer goods, especially consumer durable goods, are an indicator of spending, this picture has not been too good for us with growth of just between 2-3% in FY13 and FY14 followed by a sharp decline into the negative territory in FY15 so far. Consumer goods are the critical part as ultimately all goods have to be consumed at the end-point, i.e. the consumer. If this spending increases, then there will be positive impact on other goods such as capital, basic and intermediate.
Growth in capital goods can be an indicator of the state of the economy—but this will hold more for investment-driven countries such as China.
For India, where the share of investment is around 28-30% of GDP at current market prices, this cannot be a leading indicator. Besides, in our context, the rate of capital formation has fallen in FY15 from 29.7% to 28.6%, and does not gel well with GDP growth. But growth in final consumption at current prices has also slowed down, which again sends a different signal.
However, the best leading indicator of the economy is growth in bank credit. While the ratio of bank credit to GDP is a little less than half, this indicator captures very well the mood in industry and service, which is the non-agricultural sector that has its own leading indicators. In fact, there is a strong correlation between growth in GDP at constant prices and growth in credit. For the longer time period 1953 to 2014—based on the earlier series of GDP, it was 0.30 and for the last 30 years it was 0.49. The same coefficient increases to 0.65 for the last 10 years. Here the absolute levels are compared, which means that high growth in credit normally is associated with high growth in GDP too. It sounds logical in our context, where banks are the main source of finance for both working capital (short-term) as well as investment (long-term loans). If bank credit is growing, then it would necessarily mean that companies are borrowing for running their business (working capital).
Curiously, in years when growth in credit has slowed down, as in the last three years, the limited growth in credit had come from the retails segment while that to industry and services remained muted.
Growth in credit during the financial year is a sharper indicator, i.e. build-up over March relative to the year-on-year numbers. For FY15, for instance, up to March 6, growth was 8.8% as against 12.6%, while on a year-on-year basis it was 10.2% as against 14.3%. The year-on-year numbers can be slightly misleading if there is a preponderance effect of the previous year in this number as it includes months of the previous year too. However, these numbers do converge at the end of the year.
Hence, there is a strong case for using bank credit growth in India as the leading indicator of non-agricultural growth and use this as a basis for policy formulation as it captures both the current and capital accounts of industry. The two qualifications or caveats are that when we observe this number, we need to see whether it is due to the retail segment or corporate. Second, it is also important to see whether it is relatively well-dispersed or not. This statement, however, should be interpreted with caution as there will always be sectors that are growing and others which are not. But a spectrum auction, for example, will lead to a large increase in credit, though it will mean growth in just limited sectors.
Therefore, while growth in credit is probably the best leading indicator given that it is relatively more timely, and not subject to revisions as in case of all real indicators, the internals also need to be studied to draw firm conclusions.
The author is chief economist, CARE Ratings. Views are personal