Growth in the time of demonetisation

On November 8, 2016, Prime Minister Narendra Modi took the bold step of demonetising ₹500 and ₹1,000 notes, sucking out almost 86 per cent of India’s currency in circulation at the time. Two weeks later, former Prime Minister Manmohan Singh called it “organised loot and legalised plunder” which could reduce India’s gross domestic product (GDP) growth by 2 per cent.

Many other pessimists joined in, predicting “long-term” pain for the Indian economy along with doomsday scenarios. A Bloomberg poll pegged growth for the quarter at 6.1 per cent. At the same time, the Economic Survey was more optimistic, predicting a reduction in GDP growth by only 0.25-0.5 per cent on a baseline of 7 per cent. Economists who emphasise the importance of debt for growth, praised the move by claiming that it would reduce interest rates and boost growth due to excess liquidity and increased lending capacity of banks.

Recently, the Central Statistics Office (CSO) released the quarterly estimates of India’s GDP for the “demonetisation quarter”, the third quarter of 2016-17. As opposed to grim forecasts by the critics of demonetisation, the Indian economy grew at an impressive 7 per cent, retaining the tag of world’s fastest-growing economy. As soon as the estimates were released, optimists celebrated by claiming that this vindicates the Government’s stance that demonetisation would not slow down growth significantly. The pessimists were quick to question the credibility of the data, while some conceded that the Government is “innocent until proven guilty”. So, the important question about demonetisation becomes, to celebrate or not to celebrate? As is usually the case in India, the answer lies somewhere in the middle.

There is some merit to the claims of the optimists. CSO estimates in many segments are in line with market expectations for Q3 FY17. The financial and real estate sectors, which were among the worst-hit, grew only at 3.1 per cent (year-on-year) as compared to 7.6 per cent and 8.7 per cent in the previous two quarters. Another sector expected to be hit by demonetisation was construction, which grew at 2.7 per cent as compared to 3.4 per cent in the previous quarter. Exports grew at 3.4 per cent as compared to -0.9 per cent in the previous quarter, on the back of strengthening global demand. As expected, “agriculture, forestry and fishing” which recorded a growth of 6 per cent as compared to 3.8 per cent in the previous quarter, were among the major drivers of growth in this quarter.

The growth in agriculture, which accounts for 60 per cent of GDP in this segment, can be explained by two factors. The first is the increase in sowing and output of rabi crops due to good moisture content in the soil following a near-normal monsoon season. The Government had also provided relief to farmers in November, allowing them to purchase seeds with the old notes from government-affiliated centres.

According to the Department of Agriculture and Cooperation (DAC), rabi sowing was up 7 per cent from the previous year and production growth of foodgrain during this rabi season was 6.3 per cent compared to 2 per cent last year. The second is the base effect. The growth in “agriculture, forestry and fishing” in Q3 FY16 was minus 2.2 per cent. Thus, the recorded growth of 6 per cent in Q3 FY17 was on a low base.

That being said, there is room for scepticism while assessing the CSO estimates. Critics have questioned four surprises in the quarterly estimates for Q3 FY17. First, gross fixed capital formation (GFCF), an indicator of private investment in the economy, grew at 3.5 per cent in spite of having contracted for the previous three quarters. Given the overall capacity utilisation of companies in India at around 70 per cent and the negative impact of demonetisation on short-term demand, this number surprised markets. Second, private final consumption expenditure (PFCE), an indicator of consumption of individuals in the economy, grew by 10 per cent compared to 5 per cent and 7 per cent in the previous two quarters. While people have pointed to strong consumption during Diwali and the 7th pay commission awards, there is lack of strong evidence to justify a 10 per cent increase in private consumption. Third, the manufacturing sector grew at 8.3 per cent compared to 6.9 per cent in the previous quarter. Finally, one of the biggest surprises is the mining sector which grew at 7.5 per cent compared to minus 1.5 per cent in the previous quarter. Industry GDP grew at 6.6 per cent, which is especially surprising since other indicators like the purchasing managers’ index (PMI) dipped in November and December.

There are two potential explanations for the surprises in manufacturing and mining: commodity prices and methodology. Economists have suggested that an increase in the prices of commodities, ranging from oil to metals, may be driving the strong growth in mining and manufacturing. Also, advance estimates are largely based on data from the formal sector and may underestimate the impact of demonetisation, since the informal sector is said to have suffered a larger impact. This bias might help in explaining some of the numbers. For example, mining numbers have been calculated by looking at sales of large listed mining companies which have done very well in the third quarter.

In spite of potential biases in CSO’s advance estimates, it appears that pessimists have exaggerated the extent and length of the demonetisation shock. It seems that the hit to India’s GDP growth will not be 2 per cent as claimed. Also, the rise in PMI to 50.7 in February shows that the Indian economy has bounced back, following a “V-shaped” recovery. However, optimists should not rush to declare victory.

To get a more accurate picture, we will have to wait for CSO’s revised estimates which will be based on a wider range of data sources. For now, people on both extremes have to make their way towards the middle. To paraphrase Morgan Stanley’s Ruchir Sharma, “India is a country where estimates disappoint both the optimists and the pessimists.”

The writer is an assistant professor of finance at IIM-Trichy