Gauging the strength of the economic recovery
Second-quarter gross domestic product (GDP) data should give some comfort to the Narendra Modi government. GDP growth rebounded from a three-year low of 5.7% in the first quarter to 6.3%. Gross value added—the preferred indicator to gauge economic activity—expanded by 6.1%, compared to 5.6% in the previous quarter. The highlight of the quarter was the manufacturing sector, which registered growth of 7% against 1.2% in the preceding quarter. Growth in the agriculture sector was disappointing; this is being attributed to the higher base of the last fiscal.
Overall, data suggest that the economy has bottomed out and growth in the remaining part of the fiscal is likely to get better, partly because of a low base. Encouragingly, growth during the second quarter was driven largely by the private sector and not government expenditure, as was seen in the previous quarter. While this is a welcome development, it is important to note that the growth in economic activity is still below potential and is not guaranteed to move to a sustained higher growth path in a hurry for at least four broad reasons.
First, the dip in first-quarter growth was partly explained by destocking before the implementation of the goods and services tax (GST). Therefore, it is likely that growth in manufacturing is in part due to restocking, which will not happen every quarter. Further, it is not clear whether supply chains that were disrupted by demonetization and the implementation of GST have been rebuilt. It is likely that the nature of the supply-chain networks will change with greater formalization of the economy and compliance requirements under GST. While this will increase efficiency in the long run, and will also help in measuring economic activity, it could delay recovery in the short run.
Second, private-sector investment continues to remain weak and until it picks up significantly, it will be difficult to argue that growth will rebound to higher levels in a sustainable manner. Although capital formation showed an uptick in the second quarter, its share in GDP has slipped far below the levels seen in the high-growth years of the last decade. One of the reasons for this is that there is still a fair bit of spare capacity in the system, indicating that the recovery could be a long-drawn process.
Third, exports continue to disappoint. At a time when the global economy is witnessing a synchronized recovery after many years, exports during the quarter went up by just 1.2%. Part of the weakness can be explained by demonetization and GST-related disruptions, but there are other structural issues affecting exports. For instance, a recent study by CRISIL showed that the “revealed comparative advantage” of some of our labour-intensive sectors has been declining for a decade now. Therefore, to be able to take advantage of an important driver of growth, it is critical that all structural issues impeding exports be addressed.
Fourth, the economy is unlikely to get much support from either fiscal or monetary policy in the foreseeable future. The government front-loaded its expenditure and does not have the fiscal space to support growth in the current year. Also, the slowdown in government expenditure indicates that it wants to keep fiscal deficit close to the stated target. However, the revenue position is still not very clear and the government’s firepower, to a large extent, will depend on how well the economy adjusts to GST. Revenue buoyancy will open up space for more spending, but a shortfall could affect capital expenditure and growth. On the monetary side, because of firming commodity prices, the rate-setting committee of the Reserve Bank of India is unlikely to cut policy rates in the near term. Higher commodity prices can also affect profit margins and growth.
To be sure, there are also a number of positive factors that will help growth in the medium term. The government is working on an ambitious bank recapitalization plan which will help address the twin balance-sheet problem. Further, GST-related issues are being actively addressed by the government and it is likely to carry this process forward. In fact, a number of things, such as activity in the industrial sector, pick-up in exports, and the ability of the government to support growth depends on how well the economy adjusts to GST. Additionally, the global economic environment is favourable and should help the Indian economy both in terms of exports and capital flows in the coming quarters.
Overall, it is satisfying that the slide in economic growth has ended, but the actual strength of the recovery will only become clear after a few quarters.
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