Instead of deflating output and input with their respective prices, the statistics agency deflates both with a common output deflator. Therefore, when input and output prices are moving in opposite directions, a bias can arise
The July-September 2019 (Q2 FY19) GDP growth data came in at 7.1% y-o-y versus consensus expectations of 7.5%. To be sure, markets were expecting a slowdown, from 8.2% in Q1 to 7.5% in Q2. But the actual slowdown was harsher, leading to worries and growth forecast downgrades around the market.
Alas, there may have been an element of growth underestimation embedded in the Q2 print. And it is to do with deflators. A proxy of input and output price inflation suggests that Q2 stood out as a quarter in which the two price inflation indices moved in opposite directions. The Statistics Office’s practice of single deflation, instead of double deflation, can lead to an under/over-estimation of real growth during such episodes.
In an earlier note, HSBC had warned that when oil prices were low, and input price inflation was falling, while output inflation continued to rise, there had been a tendency of growth overestimation. And when oil prices begin to rise, and output prices take time to adjust, the situation could reverse. This seems to have transpired in Q2.
For most sectors, the statistics agency starts off by calculating “gross value added” (GVA), a measure of economic growth, in nominal terms. Put simply: GVA = economic output – input. Subsequently, it deflates nominal GVA to get an estimate of real growth. And this is where the challenge starts: Instead of using a double deflation process, the current practice is to use single deflation. In other words, instead of deflating output and input with their respective prices, the statistics agency deflates both with a common output deflator. If input and output prices are moving in the same direction, there is no scope of over/under-estimation. However, when input and output prices are moving in opposite directions, a bias can arise.
A thought experiment illustrates this clearly: Say the nominal output value is $100, while the nominal input value is $10. This yields a nominal GVA of $90 (100 – 10). Now, assume the output price is $1/unit, while the input price is $5/unit. Double deflation would mean that the real output is 100 (100/1) and the real input is 2 (10/5), resulting in a real GVA of 98. However, using single deflation, i.e., deflating both output and input by the output price, leads to an underestimated real GVA of 90 (100/1 – 10/1). And this may be what transpired in the Q2 data, likely showing up both in manufacturing and parts of services.
Much like the Statistics Office, actual input and output data is not handily available. But we do have proxies. If the CPI is a proxy of output prices, and the WPI is a proxy of input prices, the two moved in different directions in the quarter, after having moved in the same direction for several quarter. In particular, WPI rose, while CPI fell, leading to a possible growth underestimation.
This observation also holds when other measures of input and output prices are used, namely WPI input inflation and core CPI inflation. Unfortunately, the exact quantum of underestimation is hard to gauge because the breakdown of GVA into output and input is not available. Fortunately, this underestimation may not last for too long. It could show up again in the quarter ending December.
Beyond that, forecasts suggest that input price inflation will begin to ease off, due to the recent fall in oil prices, and the divergence between input and output price inflation may not remain. The bigger point here is that whenever prices move in different directions, it is safe to interpret growth numbers with care.
-The author is Chief economist, India HSBC Securities and Capital Markets (India)
Edited excerpts from HSBC’s India Economics Comment (December 10) Co-authored by Aayushi Chaudhary, economist with HSBC Securities and Capital Markets (India)