The GDP growth number for 2017Q2 was bad, very bad. It came in at a y-o-y growth of 5.7 %. Just to provide a perspective on the low growth reported—the eighth-worst quarter since 2011, and the fourteenth worst quarter since the start of the high growth period in FY04. You want more evidence on the lowness of this growth number? The average GDP growth for the two years prior to the Modi election of May 2014 was 6.4%; even if for the rest of this fiscal year GDP growth averages an unlikely 6.5% each quarter, the fiscal year numbers will not match the UPA average for their bad years! Yes, that is how bad GDP growth is today.
It is imperative that the political and economic policymakers in the Modi government identify the cause of this downturn. National elections are just 18 months away, and does the BJP believe that a growth rate below the UPA’s worst years will not dent its popularity? Prior to the 2017Q2 number, the favourite refrain of the Modi detractors or Congress supporters (same set of individuals!) was that the high GDP growth rate in FY15 and FY16 (7.5% and 8%, respectively) was caused by political manipulation of the figures by the Central Statistical Organization (CSO); the critics were too politically correct to say so openly, but they clearly implied that the CSO was fudging the numbers at the behest of the government. Now that the GDP numbers conform to their political priorities, there is not a squeak from these doubters; these critics-without-base should either come out with their latest updates on GDP growth in India, or at least apologise to the CSO for doubting their integrity and expertise. The media and economic experts have noted the phenomenon of low growth, and have offered two explanations. The most common, near-universal explanation, is the equivalent of “the butler did it”. Or, the closest, most proximate (and, coincidentally, most popular with the anti-Modi crowd) cause of the slowdown is demonetisation.
Besides convenience, this explanation has some theory to back it up; if, for a cash-dependent economy, you remove its lifeline of cash (over 86% of cash was demonetised on November 8, 2016), then obviously you will get a crash as output. As the “experts” point out with glee, a 2% decline in GDP growth was exactly what was predicted by them to be the consequence of demonetisation. Growth has shown a big decline, and the world economy is booming—so, India is in low-growth mode because of demonetisation.
The second most-popular explanation centres around the appreciation of RBI’s nominal, 36-country real effective exchange rate (REER). Some noted economists are behind this logic—hence, this hypothesis deserves serious examination. For the moment, let it be noted that for the first eight months of this year, exports (in dollar terms) are up 12.1%, while the REER has appreciated by 4.8%. For the last six years, and excluding the bad trade year of 2015 (export and import growth were -15% and -12%, respectively, in 2015), both export growth and REER appreciation in 2017 are the highest observed!. Between 2012 and 2016, export growth had averaged 0.3%, and REER an average depreciation of 1.6 %.
For the moment, the export explanation for the slowdown is perhaps even less meaningful than demonetisation.So, what does explain the downturn? Bad weather or bad karma? Maybe the latter. One fact noted by some objective experts is that the growth slowdown preceded demonetisation. After hitting a peak of 9.1% in 2016Q1, quarterly GDP growth registered 7.9% and 7.5% in the subsequent quarters, i.e., at the time of demonetisation on November 8, 2016, GDP growth was already down to 7.5%, a full 1.6% below the peak reached just two quarters earlier. If one has to explain the growth slowdown without recourse to conspiracy theories about data manipulation (we can’t really do that now because growth is lower, much lower, than what the so-called data manipulators would like!), one has to begin to answer the following two questions: What determines growth, and which of these determinants was flashing a red signal before demonetisation.
In most countries (strike that, and replace with “all countries except a unique country called India”), the above question has the same answer—look at interest rates, stupid. No matter what country, central banks and government officials have the same answer and the same policy: To increase demand (up the GDP growth rate), decrease interest rates; to decrease demand, increase interest rates. Why Indian macro-experts almost never offer this policy is a question I can’t answer—a psychiatrist might do much better. That interest rates do matter in India, and matter a lot, can be shown as follows. We look at only those sectors most susceptible or sensitive to interest rate policy. Agriculture can be ruled out, as it is most influenced by the weather; public utilities, public administration and defence should be excluded, as these sectors are more susceptible to the whims of bureaucrats rather than the babus in Mint Street.
Which leaves us with manufacturing, mining, services (excluding public administration) and construction. Both mining and manufacturing are problematic for any analysis because these two sectors have been plagued with high corruption, and even higher bad balance-sheets (NPAs or non-performing assets). It is likely that resolution of the NPA problem will significantly improve investments and growth, but the resolution will need a different instrument than lowering interest rates. If one takes only the interest rate-sensitive sectors (services ex public administration + construction), then one can estimate interest sensitivity of output growth. This sector can also be thought of as the demonetisation sector. Agriculture and government expenditures bias GDP growth upwards, balance-sheet considerations bias it downwards. These sectors are ignored in our calculations.
The accompanying graphic shows the relationship between the growth in the interest-sensitive (demonetisation) sector and lagged real SBI lending rates, with data presented for fiscal years from 1978 to 2015. Note the strong central negative relationship for close to 40 years! Each 100 bps increase in the one-year lagged real lending rate decreases growth by 40 bps. Between 2012 and 2014, the one-year lagged real lending rate averaged around 5%; the corresponding values for 2015 and 2016, 8.8% and 9.7%. So, annual growth in FY18 is expected to be around 2 ppts lower than that observed in 2015.
Average growth in the demonetisation sector in FY16 was 9%—hence, 7% is the expected growth for this sector in FY18. We have only two observations since demonetisation—2017Q1 and 2017Q2; sector growth rate in these quarters was 6.5% and 7.9%, respectively, or an average of 7.2%.
We don’t want to push the analysis too far in the direction that only interest rates matter; there is the weather, animal spirits, momentum, confidence, and other vaguely important factors. However, no matter what explanation you come up with, you will have to circle back to interest rates—the evidence is that strong. But go ahead, disregard the evidence. You are in good company, with the experts at RBI (and MPC). They must know better; otherwise, why would they keep real interest rates at world-beating levels?
Surjit S Bhalla
Contributing editor, The Financial Express, and senior India analyst at Observatory Group
Twitter: @surjitbhalla Views are personal