Number Theory: The Indian economy’s two paths to recovery

June quarter GDP growth of 20.1% was slightly lower than expected estimates (21.3% was RBI’s forecast and 21%, that of economists in a Bloomberg poll). The latest GDP numbers are 16.9% and 9.2% less than the March quarter and June 2019 (pre-pandemic level) quarter, respectively. What do the latest GDP numbers tell us about the state of the macro economy? The answer is not so straightforward.

Quarterly GDP numbers come with a lag of two months. In normal times, this is not a problem. But the Indian economy was battered by the second wave of Covid-19 in the months of April and May. The second wave peaked on May 9. Daily new cases are much lower today and India has administered at least one dose of Covid-19 vaccine to more than half its adult population. This, by itself , says too much reliance should not be placed on the June GDP numbers for estimating the current trajectory of the economy.

High-frequency indicators since June, when read along with the latest GDP numbers, point towards a trend which could have longterm repercussions for economic performance. This trend suggests that there are two growth trajectories in the economy.

The first is a more resilient formal sector recovery, boosted by tailwinds from removal of mobility restrictions and pent-up demand as well. Indeed, parts of this sector are facing supply-side constraints because of disruption in international value chains. Then there is the informal sector, which has taken a bigger hit to incomes during the pandemic and is now facing an inflation-driven squeeze on purchasing power. This sector has a much larger share of employment in the economy. While the formal sector can lead sequential recovery for the time being, a prolonged damage to the informal sector can damage long-term growth potential of the economy.

Here are three charts which explain this.

1) PMI data says there is jobless growth in manufacturing

Purchasing Managers’ Index (PMI) for manufacturing was at 52.2 in the month of August . This is the second consecutive month when PMI manufacturing was above the psychological threshold of 50, which signifies an expansion in economic activity compared to last month. To be sure, the August PMI value was lower than the 55.2 figure recorded in July, which suggests a deceleration in momentum of recovery. “August saw a continuation of the Indian manufacturing sector recovery, but growth lost momentum as demand showed some signs of weakness due to the pandemic”, Pollyanna De Lima, Economics Associate Director at IHS Markit, the agency which conducts the PMI survey said in a press release. Demand side concerns are also generating headwinds for employment, despite a rise in vaccinations and removal of mobility restrictions, which in a way, neutralises the gains on the pandemic front. “Uncertainty regarding growth prospects, spare capacity and efforts to keep a lid on expenses led to a hiring freeze in August, following the first upturn in employment for 16 months in July”, Lima added.

2) There is a class divide in demand-supply mismatch

A Bloomberg Quint story of August 31 reported a peculiar crisis facing India’s automobile dealers. While car sellers are battling with a supply-side crisis, so much so, that they fear festive season sales might suffer, the two-wheeler market is facing an acute crisis of demand. Numbers from the Centre for Monitoring Indian Economy (CMIE) database capture this trend clearly. Cumulative domestic sales of passenger cars between April and July reached 82.8% of April-July 2019 levels. This number was just 56.1% in case of two-wheeler sales. The slump in two-wheeler sales is most likely driven by headwinds for incomes of relatively poor households from the pandemic’s shock and current levels of inflation. The effect of squeeze on mass incomes can also be seen in the latest Goods and Services Tax figures which fell from ?1.16 lakh crore in July to ?1.12 lakh crore in August, even though mobility restrictions eased between July and August.

The supply-side crisis for car makers is a global phenomenon and a result of disruption of microprocessor production in south-east Asian countries while demand has surged globally. The shortage of microprocessors could also be a problem for home appliance markers, another Bloomberg Quint story said. This peculiar mismatch in demand-supply is bad news for the economy. A supply-side crisis in commodities bought by the relatively rich is delaying income generation and also fuelling inflation, both of which will generate more pain for the incomes and demand of the not-so-well-off.

3) The link between fiscal capacity and inflation

In real terms, GDP for the quarter ending June was 9.2% lower than the pre-pandemic level of June 2019. The story is very different if one looks at the nominal GDP numbers, which were 2.4% higher than the June 2019 value. This comparison brings to fore the importance of inflation in Indian economy at the moment. At 11.6 percentage points, the nominal growth component (difference between nominal and real growth) in the June quarter was the highest since the quarter ending March 2010 and the fourth highest ever since the quarter ending June 1997, the earliest period for which CMIE database has quarterly GDP growth data.

While part of the current inflationary spike is driven by external factors in commodity markets, the petroleum product price hike (and its cascading effects on general price levels) is a direct result of a hike in union excise duty which has not been rolled back despite a significant recovery in crude oil prices. While this has led to a rise in inflation, union excise duty collections are a significant fiscal cushion for the government at the moment.

Latest numbers from the Controller General of Accounts (CGA) show that union excise duty collections were 14.4% of the Centre’s gross tax revenue for the April-July period. While this is lower than the 17.9% share for the April-July 2020 period (most of the economy was under lockdown in April and May 2020 and other tax collections were very low), it is higher than the 10.2% share for April-July 2019. Also, union excise duty collections in April-July were significantly higher than the April-July 2019 period, even though petrol-diesel consumption has still not reached pre-pandemic levels. These statistics capture the dilemma facing the union government. It can continue to tax petrol-diesel, collect more money in taxes and keep up its capital spending. But this is bound to fuel inflation, and more importantly inflation expectations, which have risen sharply during the pandemic. This heightens the risk of an inflationary spiral which will hurt informal sector income and demand even more. What makes matters even more complicated is the fact that the fiscal arm of policy making cannot expect any relief from the monetary policy flank, which is bound to begin policy normalisation going forward.