Fast changing growth-inflation dynamics

The contraction of India’s real GDP at 7.5 per cent in Q2 FY21 was much better than expected by professional forecasters as against a deep contraction of 23.9 per cent in Q1. This has brightened a V-shaped recovery of the economy going forward.

Pessimists predicting U/L/K-shaped recovery have been silenced. Even the RBI’s predictions of GDP contraction in Q2 FY21 (9.8 per cent in October 2020 policy and 8.5 per cent in the current forecast) were on the higher side (Table 1).

In the December 2020 policy, the RBI has drastically revised India’s GDP contraction to 7.5 per cent for FY21 with both Q3 and Q4 expected to witness positive growth. The median growth projection by professional forecasters however remains higher at 8.5 per cent for FY21. On the other hand, the RBI has revised the inflation projection significantly upward compared to October projection. This has evoked widespread debate on whether the RBI has over-predicted growth and/or inflation after the Q2 GDP and October CPI inflation numbers were available.

The worst GDP contraction due to stringent lockdown is certainly behind us. Despite the multi-speed recovery, all segments of the economy have shown upward movement. The Covid-curve is steadily on the downswing amidst the availability of anti-Covid vaccine soon.

The unlock impact

As unlock since Q2 was sequentially rapid, it was natural for Q2 recovery to be sharp V-shaped from a rock-bottom level of GDP. The Q2 performance of the manufacturing sector, in particular, was surprisingly positive as against the deep negative anticipated by forecasters. This is attributed to the restocking of manufactured products besides most of the pent-up demand being released in the wake of the ensuing festival season. Discretionary spending of the households seems to have started since Q2 following the phased unlocking of the economy.

Although the economy is on a fast track to recovery, will the Q2 momentum continue and the Q3 GDP growth be positive going forward? There are several reasons to believe that the near term growth outlook is still uncertain.

The pain points

First, data on the informal sector, which has been hit hard during the lockdown, are currently not available. Based only on IIP data, one is not sure whether the manufacturing sector would maintain speed once the festival season is over.

Second, as India’s resumption of economic activities by end-December is about 90 per cent, it is impossible to have positive growth in Q3.

Third, resumption of activities does not mean these sectors have started operating at the pre-Covid level of capacity utilisation.

Fourth, capacity utilisation at the end of Q2 was about 62 per cent and may be well below 70 per cent in Q3.

Fifth, the services sector, which is the biggest contributor to the GDP, is yet to be fully normal. The contact-intensive services sector cannot be fully functional until the vaccination process is completed.

Sixth, India’s export sector would suffer a setback due to slowdown of western countries following the second wave of Covid attack in the winter season.

Hence, India’s Q3 GDP in FY21 is most unlikely to be positive. In Q4, if we reach the level of last year’s nominal GDP that itself will be an achievement (Table 2). The real GDP is likely to contract by 9 per cent in FY21. To reach the FY20 level of real GDP, the Indian economy should grow by 9.9 per cent in FY22. India is at least two years behind the schedule to reach the target of $5 trillion.

Most of the econometric models typically over-predict during recovery and under-predict during the downswing of an economic cycle. April-June quarter is an exception as the unprecedented contraction was due to Covid-related lockdown. Had there been no Covid crisis, India’s economic slowdown would have bottomed out in Q4 FY20.

Over the budgeted level, the expected nominal GDP contraction of ₹35 trillion in FY21 would be a permanent loss to the economy. Its second-round impact on loss of demand is largely offset by the Atmanirbhar packages of nearly ₹30 trillion (about 15 per cent of GDP).

India’s growth outlook is not as optimistic as projected by the RBI. Although many forecasters have trimmed India’s real GDP contraction after Q2 GDP, they still maintain it around 9 per cent such as Nomura (-8.2 per cent), S&P Global Ratings (- 9 per cent), Fitch Rating (-9.4 per cent), World Bank (-9.6 per cent), Goldman Sachs (-10.3 per cent), and Moody’s Investors Service (-10.6 per cent).

Reforms crucial

The Atmanirbhar package is essentially work-in-progress. In the ensuing Budget, both Central and State governments have to pursue structural reforms to increase productivity and sustain a high rate of growth in the medium term. A new road-map is needed for fiscal consolidation. The investment climate has to improve further for the animal spirits to return. Public investment can supplement private investment but it is unlikely to fully make good the declining trend in the gross fixed capital formation.

Inflationary pressures in the economy are overstated. Given a bumper harvest expected in FY21, prices of agricultural produce will correct further. Crude oil prices may continue to remain benign due to weak global demand. Both Central and State governments have the option to reduce indirect taxes on petroleum products in FY22. The Budget needs to be growth-oriented amidst the accommodative monetary policy promised by the RBI in FY22.

The writer is former Principal Advisor and Head of the Monetary Policy Department of RBI.

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