A necessary condition for GDP growth to accelerate beyond 7 % per annum is for RBI to cut rates aggressively.
GDP growth is almost an all-consuming statistic for policy-makers, academicians and market participants. However, when the new GDP growth figures were released for the quarter April-June 2015 (hereafter 2015:2), there was more darkness than light. Not entirely unexpected, since the new GDP data have been met with scepticism since being first introduced earlier this year. I have not been a sceptic, and neither am one today; while the growth figures are confusing, there is a logical, consistent explanation. This time, though, do not blame the CSO for the controversy—blame the IMF (explained below).
What happened? GDP growth for the April-June quarter came in at 7% versus market expectations of 7.4% and my own estimate of close to 9%. Many commentators and analysts were stunned by the low estimate, especially since finance ministry and other officials were publicly touting an 8-10 % GDP growth path. So, several officials (and commentators) have egg on their face. Or, have they?
What did the GDP data released by the CSO show? The new data present estimates for both gross value added (GVA) and for GDP, and the two are related to each other by this simple identity: GDP = GVA + DITS, where DITS is the difference between indirect taxes and subsidies.
Some simple facts about the three variables. First, DITS is normally positive and accounts for approximately 7% of GDP. Second, the growth rates of GDP and GVA closely parallel each other. Normally. But for 2015:2, the two growth rates diverge, and diverge by a huge amount. In real terms, both grew by a near identical rate of 7% in 2015:2. But in nominal terms, GDP grew at 8.8% while GVA grew by only 7.1%. In other words, inflation as measured by the GVA deflator was 0.0%, while inflation as measured by the GDP deflator was 1.8%. So, the explanation for the difference in growth estimates is all in the computation of the deflator; or as Clinton might say, it is the deflator, stupid.
But which of the two deflators are likely to represent the correct inflation rate in 2015:2? Before this quarter, they are near identical for all the previous quarters; between 2011:2 and 2015:1, the aggregate GDP deflator increased by an average of 6.5% a year, the GVA by 6.4%.
One indirect check on what the deflator should be is yielded by the close synthetic proxy for the GDP deflator—a weighted average of WPI and CPI inflation. Historical tests suggest an approximate weighting of two-thirds for the WPI and one-third for the CPI. Between 2014:2 and 2015:2, CPI inflation was 5.1% and WPI inflation minus 2.4%. This yields a 0.1% estimate for the implicit price deflator; strikingly close to the actual GVA deflator of 0!
That deflator inflation is close to zero is also supported by the implicit price deflator for the three supply-side sectors of the economy—agriculture (4.5%), industry (-1.1%), and services (-0.5%). Weighted by shares in GDP, this also yields a deflator close to zero.
The accompanying chart documents y-o-y quarterly inflation according to four different indicators. The services deflator inflation is introduced to emphasise that inflation decline to close to zero levels is for all sectors of the economy.
So, the real puzzle is the very high GDP deflator inflation of 1.8%—how can this number be so large when all inflation numbers suggest 0%? The answer is the very high implicit price deflator for DITS. Actual nominal growth of DITS is 33.6%; so real growth in DITS is only 6.3% which yields an implicit deflator of 27.3%!
It is not the CSO’s fault—blame it on the IMF. The IMF recommends/mandates that official quarterly estimates of GDP be based on “historical” annual estimates of real DITS. At the end of the fiscal year, all data are available and “true” estimates can obtained. So, notice what the CSO has done—it has assumed real DITS growth to be close to historical norm of 6% (as per the IMF recommendations), and allowed the very large residual to be the price change!
The GDP deflator puzzle is solved; GVA deflator accounting for 93% of GDP has a deflator of zero; and 7% (DITS) has a deflator of 27.3%. Aggregate GDP deflator inflation of (0.93*0 + 0.07*27.3) of 1.9%. Eureka; puzzle solved; QED.
So, what is the real GDP growth in 2015:2? Two methods. First, the nominal growth in GDP (CSO figures) in 2015:2 was 8.8%; with a correct GDP deflator of 0%, this direct estimate of real GDP growth would be 8.8%. Second, with DITS, one obtains (0.07*27.3) or 1.9% as the extra GDP growth missed out by the CSO/IMF estimate, i.e., GDP growth was (7 + 1.9)%. So you can take your pick—GDP growth, correctly estimated, in 2015:2 was 8.8% or 8.9%—not the reported 7%.
An additional question in search of an answer: Why has DITS grown at such an enormous rate this year? Mostly oil, and also some reduction in subsidies. Have you noticed that while the imported oil price is less than half of what it was last year, the domestic price of petrol has stayed virtually constant—OK, I exaggerate, it is down by about 10%. The government (both Centre and state) has pocketed almost the entire fall in oil prices in the form of higher taxes.
Note, oil tax revenue adds to growth in the economy, and with little extra expenditures, the extra tax revenues translate into a reduction in the fiscal deficit. Even if there are no additional gains, this 2% gain in one quarter translates into an annual reduction in the fiscal deficit of around 0.5% of GDP.
But does growth feel like 9% or 7%? Absolutely the latter, as also indicated by the growth in value-added estimates of agriculture, industry and services. So, what is the meaning of 9% growth? Assume for a moment the government suddenly discovered gold worth 2% of GDP and sold it and used all of its revenues to pare down debt. Then, GDP growth would be 9%, but feel like 7%.
This points to an important difference between the BJP and the Sonia Gandhi-ruled UPA; the UPA received a windfall gain (low oil prices) in 2009 and squandered it, possibly in the interests of winning an election. The BJP has been a lot more responsible and seems to be dedicated to doing the right thing for the economy—bring down inflation, reduce the fiscal deficit, even if it means sacrificing some short-term growth in GDP and jobs.
When and how will India see a GDP growth close to its potential of 8-10%? Of course, I mean real GDP growth of 9%, one accompanied by growth in jobs, and economy-wide growth—and not by manna-from-heaven decline in the price of oil. There are no magic wands available, but there is a time-tested policy: Make real policy rates competitive with the rest of the world. And 25 bps will just not do it. It is now over to RBI.
The author is contributing editor, The Financial Express, and senior India analyst, The Observatory Group, a New York-based policy advisory group