Demonetisation and the ‘surprise’ over high GDP numbers

Demonetisation and the ‘surprise’ over high GDP numbers

The estimated 7% growth in Q3 has rekindled the debate on the CSO's methodology. How is GDP calculated in India? What explains the growth number?

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India’s GDP growth in April-June, the first quarter of this financial year, had slowed down to 7.1 per cent from 7.5 per cent in the corresponding period a year ago.

There has been general discontent and debate among stakeholders — thinktanks, economists, investors, analysts, etc. — due to large upward revisions in growth rates after the Ministry of Statistics and Programme Implementation changed the base year for calculating national accounts from 2004-05 to 2011-12. This happened in January 2015, but what left many confused was the substantial upward revision in growth rates after the revision, which was in variance with high frequency indicators like the Index of Industrial Production (IIP), trade data, sales tax collections, etc. These did not support the high growth numbers as reflected in the GDP numbers post the change in base year.

The latest GDP numbers for the third quarter (October-December) of this financial year 2016-17, estimated at 7% by the Central Statistics Office, has rekindled the debate on the inadequacies of the CSO methodology. The largest opposition party, Congress, cried foul and accused the government of peddling wrong numbers — saying this made a mockery of those without jobs, and poor private sector sentiments.

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The Q3 GDP numbers once again present a picture that belies the general expectation that the demonetisation decision of November 8 (the second month of the third quarter) adversely impacted the informal sector. The withdrawal of high value currency notes — Rs 500 and Rs 1,000 — which accounted for 86% of the total currency in circulation, was expected to reflect in lower GDP numbers for the quarter. Even Chief Economic Advisor Arvind Subramanian said growth would take a 0.25-0.5 percentage-point hit, assuming a baseline growth of 7%. A Reuters poll of analysts had pegged the growth rate at 6.4% for the quarter ending December, much lower than the 7% that has been estimated by the CSO.

How is GDP calculated?


GDP in India is measured in two ways: by the expenditure approach or the output approach. In the output approach, the CSO measures economic activity and arrives at the total value of goods and services produced under eight different heads:

— agriculture, forestry and fishing

— financial, real estate and professional services

— public administration, defence and other services

— manufacturing

— mining & quarrying

— trade, hotels, transport, communications, and services related to broadcasting

— construction

— electricity, gas, water supply and other utility services

The problem is of timely availability of data for calculating the value of goods and services. For the manufacturing sector, data is obtained from companies in the stock exchanges and from the Index of Industrial Production. For the construction sector, data on cement production and consumption of finished steel are used. In the absence of real data, at times proxies are used. For instance, for measuring trade output, sales tax collections are used as a proxy. This value will be high if sales tax collections of states show a robust growth. The sum total of output value of these 8 sectors make up the GDP at factor cost. The expenditure approach is based broadly on the Keynesian formula: Y = C + I + G + (X – M), which is Income = Private Final Consumption Expenditure + Gross Fixed Capital Formation + Government Final Consumption Expenditure + Change in Stocks + Valuables + (Exports less Imports).

Ideally, the same numbers should be reached by using either of the two approaches. But getting the real picture of Private Final Consumption Expenditure (PFCE) is difficult — and hence, a new “Discrepancies” head inserted under the expenditure approach takes care of the difference in value reached by employing the two approaches.

What has happened in Q3, 2016-17? Why are many surprised?

Prime Minister Narendra Modi announced the demonetisation decision on November 8, i.e., in the middle of the third quarter. This hit the informal sector, which is hugely dependent on cash. IIP declined 1.9% in October, grew 5.7% in November, and again contracted 0.4% in December. Another indicator, the Industrial Outlook Survey released by the Reserve Bank of India on January 25, said the level of optimism on several parameters such as order books, capacity utilisation and imports, was lower in the October-December quarter compared with the previous quarter. Overall, the business sentiments of the manufacturing sector had deteriorated. Despite this, the Gross Value Added for manufacturing during the quarter according to the output approach has gone up by 8.3%.

Simultaneously, a snapshot from the expenditure approach to measuring GDP shows a sharp increase in Private Final Consumption Expenditure (PFCE). PFCE, which reflects the growth in output or production of consumption goods, jumped Rs 1,62,563 crore in Q3 this year compared with Q3, 2015-16. In the previous two quarters, it had increased by Rs 77,247 crore (Q2) and Rs 1,07,342 crore (Q1). Many contest this output jump since anecdotal evidence suggests that sales across industry segments dropped during the third quarter, be it automobiles, consumer durables, cement, steel or fast moving consumer goods.

But is it statistically possible? What explains the jump in Q3 GDP growth rate?

True, PFCE doesn’t reflect sales, and is actually calculated from growth in output of consumption goods. Those in the know say it is entirely possible that companies produced goods, but in the absence of genuine sales, shipped them all to dealers. In other words, they booked sales on their books, and dealers were left with the inventory. It is also likely that dealers gave cash to the companies, and the companies duly paid off excise duties. Dealers too may have been happy since they were finding it difficult to account for large cash possessions following demonetisation.

Three other reasons cited are: shift of informal businesses to the formal sector, advance spending by people after the demonetisation announcement, festival purchases were not affected since these were made before November 8. And also, huge discretionary spends or blowing up of money by hoarders before the December 30 deadline to deposit Rs 500 and Rs 1,000 notes.