India Q1 FY18 GDP miss: Transitory or Structural? What next?

Q1 FY18 GDP came in at 5.7% (YoY) way below consensus estimates of 6.5%, Q4FY17 print of 6.1% and Q1FY17 print of 7.9%. This is the worst quarterly GDP print in 3 years. GVA (Gross Value Added) is considered to be a better measure of economic growth as it is adjusted for the effect of taxes and subsidies1. Q1FY18 GVA came in at 5.6% compared to Q1FY17 print of 7.6%. These numbers indicate that growth in the first quarter was stifled by the twin effects of demonetization and uncertainties around rollout of GST. This raises questions as to whether this blip in growth is temporary or structural in nature.

Analyzing expenditure sub-components of GDP i.e. Consumption, Investment (GFCF), Net Exports: Private consumption (which has been the most significant contributor to growth recently) has taken a hit as consumer confidence has waned post demonetization. Private consumption slowed to 6.6% (YoY) in Q1FY18 compared to 7.3% in the previous quarter. Government expenditure did support the economy as government fiscal deficit reached 92.4% of full year target in the first quarter itself, compared to 73.7% in same period of previous fiscal. The heavy frontloading of government expenditure was intended to insulate the economy from the demonetization shock but clearly did not prove to be adequate enough to overcome slowdown in private consumption. The silver lining in the GDP data though was pick up in GFCF (Gross Fixed Capital Formation) which showed a growth of 1.6% in Q1FY18 compared to -2.1% in the previous quarter i.e. Q4FY17. Net exports continued to be a drag as they declined 2.6% (YoY) compared to a decline of -0.3% in the previous quarter. Another encouraging sign is the pick up in core GVA (i.e. GVA excluding agriculture and public administration services) which revived to 5.5% on the back of pick up in real estate and infrastructure sector after plunging to a series low of 3.8% in the previous quarter. This is a heartening sign and suggests that the outlook is not that gloomy.

Analyzing sector wise contribution to GDP i.e. Services, Industry and Agriculture: Recovery in service sector was broad based, led by hotel and transport and communication services growth. Real estate services also picked up as sector recovered from the demonetization shock to some extent. Growth in public administration services also held up quite well. The contribution of services to headline GVA growth increased to 0.85% from 0.67% as compared to previous quarter. As far as industry is concerned, mining growth came in at -0.7% compared to 6.4% in previous quarter. Manufacturing sector was the worst affected on account of disruption in production schedules and inventory destocking ahead of GST rollout. Manufacturing activity grew at a paltry 1.2% in Q1FY18 compared to 5.3% in previous quarter. Construction sector growth improved to 2% compared to contraction of -3.7% as continued remonetization reduced the stress on the cash intensive sector. Pick up in construction activity is evident from the rise in cement and steel output. Pace of agriculture growth slowed due to seasonal factors but is expected pick up in coming quarters on the back of a strong monsoon.

Going forward, gradual pick up in private consumption is expected. Private sector will have to shoulder much of the burden if growth numbers are to revive as government fiscal deficit is already very high as a percentage of budgeted deficit for the entire fiscal. A slight compromise on the fiscal front would however augur well if it is directed towards infrastructure building and Capex. Rural consumption is expected to pick up on what appears so far to be a second consecutive year of normal monsoons. Implementation of recommendations of seventh pay commission by state governments may also provide a fillip to urban consumption. Immediate revival in private investment however looks unlikely as long as there is negative output gap (surplus capacity) and corporates are in a process of deleveraging. Low rates and excess systemic liquidity have failed to boost credit offtake. The NPA situation of banks needs to be resolved at the earliest to unclog channels of credit flow and for private capex to pick up again. Export growth could continue to remain tepid on account of protectionist policies of several developed economies. Relative appreciation of the Rupee (on account of hot money inflows into capital markets) against currencies of other nations that compete for the same export pie could also weigh on export growth. Stronger Rupee could also result in surge in imports as they become cheap relative to domestically manufactured goods.

To sum up, growth may remain stymied in Q2 as well due to inventory destocking and discounts offered prior to the rollout of GST. However, growth should pick up from Q3FY18 onwards as most companies (including SMEs) would have adapted to the GST framework by then and effects of demonetization would have dissipated. Leading indicators such as manufacturing PMI do suggest that the worst may be behind us. Both, GST as well as demonetization are likely to result in accretion in government revenue as the size of the formal economy grows and incidence of tax evasion reduces2. The quality of Government expenditure will also play a crucial role in shaping future growth. As far as monetary policy is concerned, the baseline scenario is for a further 25bps repo rate cut in December policy if a rate hike in US seems unlikely in 2017 or if the pace of future Fed hikes appears as gradual then as it appears now. This expectation is also subject to domestic inflation being contained well below 4% with no imminent signs of upward pressure on account of factors such as Rupee depreciation, a rise in crude prices or food prices.

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1)     Nominal GDP is the sum total of all goods and services produced in an economy. However nominal GDP can increase purely on account of inflation and therefore is not an accurate measure of actual economic activity. Therefore nominal GDP is adjusted for inflation by using the GDP deflator to compute the Real GDP. In India the GDP deflator is linked to WPI. Growth in real GDP could also present a distorted picture of actual economic activity due to taxes and subsidies and therefore it is further adjusted to arrive at the Gross Value Added (GVA)

2)     According to the apex planning body, Niti Ayog’s projections, tax collections as a percentage of GDP is likely to increase to 12.3% by 2019-20 from 11.2% in 2016-17. For FY2016-17 1.26 crore new tax payers were added to the tax base.