India's Deepening Mystery: Where's the Growth?

 | Mar 02, 2017 | 9:00 AM EST
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Is India for real? Not likely, not right at the moment, is the conclusion after the release of its latest economic figures.

There's no doubt that the country's economy is on a roll. Its growth rate is the best in the world, among major economies. At an annualized rate of 7% for the December quarter, growth was almost a full percentage point ahead of expectations.

Those numbers might have been taken at face value prior to November. But that they are so strong despite what happened back then, when the government sprang one of the greatest economic shocks that the country has ever seen, beggars belief.

On Nov. 8, Prime Minister Narendra Modi surprised India and much of the rest of the world, by announcing that 500 rupee ($7.50) and 1,000 rupee ($15) notes would no longer be valid tender. That cancelled 86% of the cash in circulation. The notes had to be deposited into banks by the end of December to be considered valid. There were also restrictions on withdrawing cash that left many tourists bemoaning their inability to function on their vacation, and many sectors of the Indian economy unable to function.

The idea behind demonetization is to force India's under-the-table economy above board. The move had to be made completely unannounced to avoid people translating currency into other denominations so they could continue operating outside the reach of the tax authorities.

At least 80% of transactions in India take place in cash. The informal economy comprises around 45% of the total, but accounts for 10x the number of jobs that you'll find in "official business." So it was no surprise that industrial production tanked, turning down 0.4% in December from growth of 5.4% the month before. Export growth and the volume of imports contracted. 

That has not yet been reflected in India's economic growth. As a result, there's been considerable doubt over the figures, with some market watchers saying they simply don't believe them. 

There's not deliberate lying or obfuscating, but the way the numbers are compiled doesn't generate solid data, according to Tim Worstall, a contributor to Forbes. One problem he notes is that the numbers track the official economy, while demonetization targeted the massive black market.

Private consumption jumped substantially in the December quarter, according to the official data, despite plenty of anecdotal accounts otherwise. "Private final consumption expenditure" leaped 10.1% compared with a year ago, higher than the two quarters prior to demonetization. Inflation, though, dropped.

One reason is that the price of perishables such as vegetables plummeted. That's because farmers depend almost entirely on cash for sales. According to reports on the ground, farmers were destroying their entire crops because they were simply unable to sell anything at all.

The driver of higher consumption may have been a much more rapid rate of transfer of black money. The "informal" economy operates on a cash basis, whereas the official economy operates through the banking system. Demonetization caused a rapid jump in bank deposits, with limited opportunity to withdraw money.

This put a premium on the remaining bank notes that were still valid. So "the sharp spike in the velocity of circulation of narrow money seems to suggest that black money circulated at a fast pace, thereby raising consumption demand in the economy as a whole," Société Générale economist Kunal Kumar Kundu points out.

India's economy is likely to soon surpass China in terms of its dependence on exports, for the first time since China's then-leader Deng Xiaoping introduced economic reforms to China in 1979. India currently gets 19.4% of its gross domestic product from exports, while China sits at 20.2% and falling, compared with a peak of 38.6%, according to calculations from the Financial Times.

But India has not created a successful manufacturing sector, unlike most export-driven economies. Instead, growth in exports is coming from services, with information technology and business-process outsourcing both mainstays of the modern economy. Its exports peaked as a share of the economy in 2013, at 25.2% of total output.

However, according to the most recent GDP figures manufacturing was a key driver of the economy. The manufacturing sector's output rose 8.3% on an annualized basis, higher than the economy as a whole. That was building on record growth in manufacturing, at 12.8%, in the corresponding quarter the previous year.

That doesn't mesh, SocGen's Kundu notes, with excise tax revenue growth during the quarter, which was very weak. The manufacturing growth also occurred alongside a rise in inventory. That would have to mean that capacity must have increased dramatically. But other data show that capacity utilization is near an all-time low.

"In such a situation, how manufacturing activity can actually improve at such a pace remains anyone's guess," Kundu concludes.

Many other India watchers concur. There's no doubt there's strong growth in the economy. But quite how much is up for grabs.

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