The sharp decline in economic growth in the first quarter of the current fiscal year has brought the state of the Indian economy into sharp political focus. What lies ahead?

Most economists believe that economic growth will pick up over the next two quarters. There are two main reasons why an uptick is likely. First, monthly indicators suggest that consumer spending has begun to recover since August. Sales of cars, two-wheelers, white goods and tractors have picked up. There are positive signals from other indicators such as airport traffic, steel production and the purchasing managers index for manufacturing. Sales of packaged consumer goods continue to be sluggish, however.

Second, the surprisingly poor economic growth number for the first quarter could also be partly explained by a statistical quirk. Indian statisticians use a single measure of inflation to deflate both output and input when converting nominal to real gross value added (GVA). The fact that consumer price inflation was lower than wholesale price inflation in the quarter, as chief statistician T.C.A. Anant has explained, could have brought down the growth number—a mirror image of what happened a few years ago, when the deflation of wholesale prices provided a statistical boost to economic growth.

A consumption recovery seems to be around the corner. The problem that is widely recognized is that private sector investment activity is not picking up. New investment announcements have plummeted. Recent data from the Centre for Monitoring Indian Economy shows that the value of stalled projects increased to Rs13.22 trillion in the quarter ended September 2017, the fifth consecutive quarter of such an increase.

This column had speculated in April whether the investment cycle would turn in fiscal year 2019, given the improvement in corporate savings, the availability of non-bank finance and entrepreneurial activity in new areas. The World Bank said in May that investment would lead the Indian economic recovery a few quarters down the line. The most recent data challenge these optimistic assumptions.

The key is excess capacity in industry for the past many years, as the demand projections made during the boom years have been belied. The data on capacity utilization released by the Reserve Bank of India shows that capacity utilization was a little more than 70% in the first quarter, which means that there is enough existing capacity to meet higher consumption. Capacity utilization has to increase by around 10 percentage points before new investments become viable, going by historical experience.

The big question is whether foreign demand will strengthen to support domestic consumption of industrial goods. The Asian Development Bank has already raised its growth forecasts for most major regional economies. India and Vietnam were the two notable exceptions. Regional exports have been buoyant in recent months. The major economies in the world—the US, Europe, China and Japan—seem to be in the midst of a synchronized recovery, though the tightening of US macro-policy or a shock emanating from China in the coming years could act as a dampener. The recent recovery in global trade could put a question mark on the assumption that exports will not be a driver of Indian economic growth.

The recent improvement in consumption activity as well as a nascent recovery in exports could lead to an uptick in economic activity in the second half of this fiscal year. The statistical impact of higher deflators for inputs could also dissipate. Yet, there are reasons to worry whether there is a full-blown economic recovery ahead.

Much depends on estimates of potential growth, or the rate at which economic activity can expand without inflation drifting away from its target. Potential output is an unobserved variable. It has to be an estimate—and hence is always a topic of hot debate. However, there is an interesting chart in the new monetary policy report released by the Indian central bank that deserves some attention.

The chart shows that the Indian output gap—or the difference between actual and potential economic growth—has shrunk despite the recent loss in economic momentum. It is too early to jump to any conclusions based on data for a couple of quarters, since estimates of potential growth are made over longer time series data, but it is worth asking whether potential growth has come down. The fact that inflation accelerated while the current account widened despite the sharp drop in economic growth in the first quarter is cause for very similar worries (of course, a drop in potential growth will also bring down the equilibrium interest rate that a central bank assumes when it plans interest rate policy).

Demonetisation and the transition to the goods and services tax (GST) have led to a demand shock as well as a supply shock. The latter comes from the disruption of supply chains. These are likely to be rebuilt in the coming months, but the failure to do so could lead to either hysteresis or increasing dependence on imports for intermediate goods. The likelihood of a permanent supply shock that reduces potential growth seems low right now, but policymakers should be sensitive to the fact that it could cast a shadow over the prospects of a robust recovery over the next few years.

Niranjan Rajadhyaksha is executive editor of Mint.

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