Govt's Mid-Year Eco Review says "We Don't Know"; But CEA Arvind Subbu Should Chill

Harry Truman, US President for eight years from 1945, expressed his exasperation with economists who tried to give him equivocal answers and two sides to a picture. “Give me a one-handed economist! All my economists say, On the one hand, on the other.”

Prime Minister Narendra Modi, who would have been happy to announce the arrival of “achche din” after two years in power, will have to be satisfied with “on the other hand” answers for now, if one were to peruse his Chief Economic Advisor’s Mid-Year Economic Analysis for 2015-16, which actually lowered the projected GDP growth rate from an eight-percent-plus seen at the start of the year to something like 7.2-7.5 percent. First half GDP is lower than last year’s (7.2 percent versus 7.5 percent), which will give P Chidambaram a reason to crow over the performance of Arun Jaitley in 2015-16.

The Mid-Year Analysis, presented last Friday (18 December) by CEA Arvind Subramanian, is an economist’s delight and a common man’s nightmare since it avoids direct answers to the two basic questions everyone wants answers for: Is the economy out of the woods? Are we on track for faster growth with lower inflation?

My summary for the aam aadmi, after reading the CEA’s analysis are as follows: “Are we doing better? Well, maybe, maybe not. We don’t know if the data is good, but it must be good because independent and competent economists devised them. We are doing qualitatively better, both in macroeconomic management and tax revenues and spending, but we don’t know if that is any good for reviving growth. In fact, we are surprised why we are even doing as well as the current numbers suggest. And will we do better at least next year? We don’t know. It depends…”.

Those are my words, translated from economic mumbo-jumbo to aam aadmi–speak; the actual words used by the survey are the following:

“Understanding the real economy and the pace and strength of economic recovery is unusually difficult this year for two reasons: GDP data can be subject to a degree of uncertainty, and second, the economy is sending mixed signals with different indicators not always pointing in the same positive direction.”

The analysis notes three potential reasons for doubting the GDP data, which is based on the gross value added (GVA) methodology adopted from January this year in line with international practice. The three sources of doubt over the data arise from the fact that consumer (CPI) and wholesale prices (WPI) are pointing in different directions – the former trending down, but still positive, while the latter has been in deflation territory (negative) for the last one year. In the absence of a producer price index, the WPI (along with the CPI) is used as a proxy deflator for arriving at the real GDP growth rate.

The second and third reasons for doubting the GDP data relate to the use of volumetric measures to measure output (as opposed to market prices) and the distortion caused by high growth in indirect taxes this year, which deflates the underlying GVA (since it is based on market prices).

The analysis concludes:

“So, for the three potential sources of measurement uncertainty identified above, two tend to understate real GDP growth and one tends to overstate real GDP growth. On balance, and without appropriate data, it is difficult to know the direction of bias in real GDP growth estimates.”

A remarkable way to say we don’t know if the data is pointing us in the right direction.

However, we get better answers and a dekko at the economy’s real problems when we go one level below the headline numbers.

As the analysis points out, growth depends on four basic drivers – private consumption and investment, government expenditure, and exports.

It is obvious that only two of the four engines are firing. Exports have gone kaput, with the first half of 2015-16 registering a 17.4 percent export decline; and private investment is MIA (missing in action), thanks to corporate efforts to reduce the debt overhang. This leaves only private consumption and government spending as the engines driving growth, but even here we need to call it one-and-a-half engines not two. Reason: the increased public spending on infrastructure is being neutralised by the increase in taxation, which reduces the net expansionary impact of government spending by taking away through indirect taxes what it pumps into the economy by way of investment expenditure. The UPA obsession with fiscal deficit, and not its quality, is clearly a villain in this piece.

The difference between the first eight years of the UPA (2004-12) and the last two years, and the first one-and-a-half years of the NDA is simple: all four engines were firing during the UPA’s boom years; only one-and-a-half or two are firing right now. If this assumption is correct, it means even 7.2-7.5 percent GDP growth ought to be considered a bonus.

The analysis says as much.

“The striking finding about this year (2015-16) is that compared to the past, the Indian economy now is powered by private consumption, and government investment. This is in sharp contrast to the boom years, when the economy was powered by all four components of demand. The remarkable thing about the 2015-16 growth performance is that it continues to be as strong as it is given the weakness of exports (because of declining world markets) and private investment.”

The analysis takes pride in the quality of the NDA’s fiscal management, where the wrong kinds of spends have been curtailed and the right ones expanded (capital investment), and also that the gap between budget revenue projections and actuals are narrower than ever. But the CEA adopts an almost injured tone when wondering why these good fiscal deeds are being rewarded with a lower nominal GDP growth, resulting in lower real GDP growth.

The truly remarkable achievement of the NDA is that it has narrowed the gap between nominal GDP growth and real growth, with the figures for the first half of 2015-16 being 7.2 percent real and 7.4 percent nominal. For the full year, the projection is 8.2 percent nominal – a potential gap of less than one percent with real growth.

This should be seen as a fantastic performance, the holy grail of all economists – the achievement of high growth with low inflation.

But it is not clear how this will play out politically or even macro-economically, since low inflation tends to have a negative effect on the centre’s debt profile when interest rates are still high: inflation reduces the real value of government borrowings and repayment become lighter on the purse. With low inflation and relatively high real interest rates, debt hangs more heavily on the government’s books.

This is where the NDA government’s excellent macro-management is sounding like a pyrrhic victory. What economists should be happy about may not play well on the political landscape.

The NDA faces a few difficult-to-resolve dilemmas:

First, if only two economic cylinders are firing, reviving demand will need more public investment and hence more borrowing at a time when debt is getting costlier for the government in real terms.

Second, if the war against inflation is being won through better expenditure management and a tough monetary policy, it is difficult for it to now claim that we should ease up on both fronts – though that is the logical thing to do. Moreover, the credibility of fiscal targets will be hit if the deficit target is again tinkered with. Or, for that matter, the RBI’s inflation target.

Third, the 2016-17 budget will anyway be stretched with the increase in OROP (one-rank-one-pension) payments and Seventh Pay Commission bloating the expenditure side of the ledger. The gains could be on the private consumption side, but at the cost of potentially stoking inflation once again, especially in food.

So what are the best options for the government?

#1: It should freeze the fiscal deficit target for one year at 3.9 percent, instead of lowering it further to 3.5 percent in line with the old fiscal roadmap. The rating agencies will crib, but beyond making noises, they can’t do much as the rest of the world is doing even worse.

#2:  The government should speed up nationalised bank recapitalisation, even at the cost of higher borrowing, for this is key to resuming the lending-investment cycle. A special purpose vehicle to offload bank shares may be useful to recapitalise banks immediately while allowing the SPV to sell the shares later and pump the profits back into the government’s coffers.

#3: It may make sense for the RBI to ease up faster on lending rates, but it does not make sense to ease the inflation targets. That will needlessly revive inflationary expectations which have only now been coaxed back into the bottle. The focus should be on supply management, since inflation is not a generalised problem but concentrated in a few areas like pulses.

#4: Executive action to ease rules for business and investment are the need of the hour. If states can pass major reforms legislation, we could have growth revving up by the second half of 2016-17.

An intuitive take on growth prospects for next year (2016-17) is simple: we are likely to see growth roar away, thanks to higher government spending, a rebound from two bad agricultural years, and as a result of improving corporate balance-sheets. Looking too closely at all kinds of numbers can actually make you lose the big picture.

Arvind Subramanian should chill. The government should not worry. A cyclical upturn is underway, but the numbers don’t show it as yet. Achche din will arrive somewhere around October 2016.