Q3 Shock For DeMo Cassandras; How They Got It Wrong, And Why Q4 May Not Prove Them Right Either

There will be many glum faces among demonetisation (DeMo) Cassandras, both in the political arena and in the ivory towers inhabited by macro-economists. Reason: both of them predicted dramatic drops in gross domestic product (GDP) growth, with former prime minister Manmohan Singh famously predicting a 2 per cent GDP loss, and Ambit Capital 3.3 per cent. Others gave decline figures ranging from 0.5 per cent to 1 per cent.

The pessimists have lost this round. The third quarter (Q3) of 2016-17 growth numbers, which was bang in the midst of the DeMo crisis that peaked in November and December, have come as a shock to them. The feared de-growth is nowhere near as bad as they had imagined (or hoped) it would be. The figures, released yesterday (28 February), show a gross value added (GVA) growth number of 6.6 per cent, just 0.1 per cent below what was achieved in the previous quarter (Q2). And GDP growth (which is GVP plus taxes minus subsidies) was at 7 per cent, a 0.4 per cent drop from the second quarter’s 7.4 per cent, but still a respectable number given the dire forecasts given for the economy.

India will probably remain the fastest-growing economy this year too, and the Central Statistics Office’s (CSO) second advance estimates for 2016-17 put GDP growth at 7.1 per cent, which would be 0.8 per cent below the revised figures for 2015-16 of 7.9 per cent.

With Q1, Q2 and Q3 yielding GDP growth of 7.2, 7.4 and 7 per cent, it is statistically impossible for growth in the last quarter (January-March 2017) to collapse below 6.6 per cent for the whole year, even assuming GDP in Q4 hits a low of 5 per cent. On the other hand, with the cash crisis now well and truly over, the chances are the economy will do better in Q4 than how it performed in Q3. It makes no logical sense to claim that an economy will do worse when it is recovering than when it was reeling under a shock.

To be sure, the pleasant surprise of 7 per cent in Q3 is said to be the result of two favourable factors – the revival in agriculture, which reported GVA growth of 6 per cent during the quarter, and the favourable base effect, with the third quarter of 2015-2016 fiscal year showing a dip in GVA over the second quarter, falling from 8.4 per cent to 7 per cent. Thus, the 6.6 per cent GVA growth in the 2016 third quarter was helped by the lower base of the previous year.

But these blips do not quite explain why anecdotal evidence of a sharp drop in business, especially in the trade and informal sectors, has not significantly impacted the third quarter GDP numbers.

In the eight sectors that the CSO classifies economic activity, only two (construction, and financial services, real estate, and professional services) reported a drop in GVA growth over the second quarter. While construction dropped from 3.4 per cent to 2.7 per cent, financial services and real estate dropped like a stone from 7.6 per cent to 3.1 per cent. These, clearly, were the direct impact areas of DeMo. The impact, clearly, did not carry through to the remaining six sectors.

The Cassandras have now gone on to say that the real impact of DeMo may now come in the fourth quarter. Aditi Nayar of rating agency Icra has been quoted by Mint as saying that the early GDP estimates rely on figures from the formal sectors, and thus the final numbers for the third quarter may be revised downwards.

She is surely on to something. To this we can also add that the deceleration and income losses reported in the cash economy may feed through to lower demand from the rural sector in the fourth quarter. The secondary and tertiary order effect of a demand crunch in one quarter may well linger in a subsequent quarter, if not further.

But we need to counter this argument with the possibility that if DeMo merely postponed demand for consumer non-durables and durables, we should see a bounce-back in the fourth quarter. The property I did not buy in November-December may well be bought in January-March.

Consider the case of the auto sector. Maruti Suzuki has reported back-to-back increases in domestic sales in January and February 2017, by 26 per cent and 11.7 per cent respectively. While February data is still to come in for many companies, in January, eight of the 13 auto sector players (car and two-wheeler makers) reported a rise in sales or at least flat growth. The only real losers were Hero (the market leader, which operates in the most price sensitive zone) and Bajaj Auto (which is in the power bikes category, and hence more vulnerable to demand swings). This explains why Rajiv Bajaj railed against DeMo a few days ago. But February may bring better news for both these big players too.

While the spike in agriculture in the third quarter may explain a part of the growth, in the fourth quarter we could have better news from the export and consumer sectors, now that DeMo is well and truly over, and banks are raring to lend to consumers and property sector at low rates.

The lesson Cassandras (and optimists) need to learn, apart from humility, is simple: when something as big as demonetisation of 85 per cent of issued currency happens, you cannot know what the net impact of it will be in advance. Human beings and corporations respond to negative stimuli by changing their strategies. Demand may shift from one product to another, people may use more digital currency, and the need to reduce inventory may lead to price cuts and thus greater demand in the next quarter. Hence the final impact of a big move may be less (or occasionally more) that one would expect.

For example, when DeMo crimped demand, and given the small window they had to deposit demonetised currencies, it would have been logical for black money holders to deposit money in banks and show it as sales income. This may be one reason why manufacturing showed a growth of 8.3 per cent, when most newspaper reports talked of a fall in sales. The sales may be fictitious, but the GVA numbers are real to the extent the unaccounted part of the economy (representing past sales) is now being counted.

In the fourth quarter, where economists are again hoping their dire forecasts will come true and save their reputations, we could again see normal growth, for several reasons: pent-up demand surfacing, higher export growth, and the continuing need to window-dress annual results. Government spending also peaks in the fourth quarter.

One thing is clear: India is recovering rather quickly from the DeMo blow. The only ones not on the path to recovery are the Cassandras.