Opinion
India’s IIP is losing its relevance as a lead indicator of economic growth
Summary
- We need a better updated measure that’s value-based if this index is to serve as a leading signal of the Indian economy’s trajectory.
When thinking of growth, policymakers, economists and markets usually gravitate towards gross domestic product (GDP) as the key barometer. Still, in an era of abundant information availability, high-frequency indicators enable agile policymaking, providing early signals on evolving economic backdrops. In India, even as the suite of high-frequency data has become richer, the original activity gauge, that is the monthly index of industrial production (IIP), which is considered a ‘leading’ indicator of the economy, is slowly losing its relevance. IIP prints are increasingly proving to be out of sync with GDP trends and often produce results that contrast with other macro data, like external trade, the annual survey of industries (ASI) and company results.
In the period between fiscal years 2011-12 and 2022-23, India’s real GDP has expanded at a compounded annual growth rate (CAGR) of 5.7%, while IIP has grown by just 3% per annum, according to official data. This divergence is more visible in level terms: the absolute size of real GDP as of 2022-23 is 83% higher than the base year of 2011-12, while the IIP is only 37% higher. This divergence becomes even more stark when one digs into the data. While output of the power and mining sectors can be calculated based on how much electricity is produced or tonnes of coal mined, for manufacturing, measuring only the volume of goods produced does not suffice. Similar to the divergence between headline IIP and GDP, there is an almost 3 percentage point gap between manufacturing GDP growth and the corresponding IP measure over the past decade.
The gap is most prominent for investment activity. The capital goods IP, which is supposed to be a monthly tracker of investment, has essentially remained flat (~0.03% growth on a CAGR basis) in the past decade, while gross fixed capital formation (GFCF) has expanded at an annual rate of 5.6%. This is also at odds with other investment-related indicators such as public capex, capacity utilization of the industrial sector and the BSE capital goods index, which, especially post-pandemic, show a clear and persistent upward trend.
Why does this difference arise? To understand this issue, one needs to look at the difference in methodology and construction of the IIP versus estimation of GDP. The IIP is largely a volume measure of production. Put simply, the IIP will count the number of passenger vehicles or tractors produced in any given period and compare it with a base year. Production across sectors is compiled and turned into an index form. But these items themselves will have widely different values. Less than 20% of the IIP takes into account the value of goods produced. Our GDP, on the other hand, is a value-added measure that essentially considers the value of final output produced, both in nominal and real terms.
Another issue with the current IIP series is that it doesn’t account for improvements in capacity or technological changes. The weights of the index are fixed at the base year of 2011-12. So, looking at the production of newer goods such as smartphones, which are now being manufactured in India, the IIP picture is often incomplete. Data from the Union ministry of trade and commerce shows that exports of ‘telecom instruments’ totalled $12 billion in 2022-23, more than double the $4.8 billion recorded in 2019-20. But ‘mobile and telecom instruments’ data in the IIP suggests that this sector has shrunk by 3.2% on average over this period. Of course, trade data is in nominal terms and IIP in real terms, and hence these growth rates are not strictly comparable, but it is difficult to argue that India’s mobile production has declined since the pandemic. With its current weights, the index seems to be skewed more towards auto and auto components than other industrial products, considering the near synchronicity between trends in auto production and capital-goods IP.
We are not among the first analysts to flag the discrepancy or question the representativeness of the IIP. A study by M.C. Singhi (2011) analysing the IIP on an earlier base found that the “fixed weights system of IIP is not amenable to incorporate new items," and hence suggested the need for a base closer to the current year. The study also concluded that the IIP’s downward bias has not only persisted but this trend appears to have become more entrenched. A study by the National Institute of Public Finance and Policy in 2017 states that “deciphering the actual change in production continues to be a difficult task" with the IIP.
A validation of the IIP as a measure of economic activity is critical, as its data is used in quarterly estimations of GDP (annual GDP estimates are compiled using more-complete ASI information). There is an urgent need to move towards a more updated, value-based measure of industrial production if the index is to hold value as a leading indicator of the economy’s trajectory. A periodic reconciliation of IIP data with ASI information would facilitate a validation of the index.
However, given that ASI data only comes with a lag of 2-3 years, if numbers are made available on other industrial activity indicators, such as retail sales, it would help confirm the IIP’s accuracy on a more frequent basis. An accurate assessment of quarterly GDP is necessary for policy analysis and decision-making. Hence, a retooling of the IIP is long overdue.
