India : What happens when real GDP is higher than nominal?

The growth data for the fourth quarter of financial year 2014-15 has attracted commentary for many reasons. For example, divergent growth paths indicated by gross value added (GVA) at basic prices and GDP at market prices; steady deceleration for the last two quarters in 2014-15; the usual disconnect between the new GDP estimates and leading economic indicators and so on.

Largely unnoticed, though commented upon by a couple of analysts, has been the slippage of nominal GDP growth below real GDP—at 6% year-on-year, GVA at current prices came in below the 6.1% GVA at constant prices—implying that the implicit GDP deflator has turned marginally negative! In fact, the quarterly implicit GDP deflator has been declining sharply since its 8% peak in the third quarter of 2013-14, according to the new GDP data (see graph). What does this signify?

Even before we respond to this particularly important question that has far-reaching policy implications, let us first try to understand what explains this trend? Put differently, why should the implicit GDP deflator be so much at variance with the headline CPI inflation? Statistically, the answer lies in its composition, which includes both the CPI (mostly for services activities) and the WPI as a close substitute for producer prices or PPI (mainly for industrial and agricultural activities) to deflate GDP estimates at current prices into constant prices in the base year. While headline CPI inflation has fallen more than 200 basis points in the second half of 2014-15, it is the negative trend in WPI from November 2014 that mostly explains the sharp decline of the implicit GDP deflator.

A logical question, therefore, is if this trend is temporary or likely to sustain its downward momentum. The answer depends on future projections of CPI and WPI inflation. While RBI has projected CPI inflation to increase by 100 basis points from its current 5% level to 6% by January 2016, its monetary policy framework aims to achieve 4% CPI-inflation by January 2018. Given the increasing divergence between the headline CPI and WPI inflation—currently at 750 basis points—it is reasonable to assume that WPI inflation could remain in the negative zone in the same time period. What is even more pertinent in this regard is that core-WPI inflation also turned negative in the last two months, while its divergence from core-CPI inflation widened by more than 400 basis points.

Thus, looking ahead, it seems realistic to expect that GDP growth at current prices, i.e. nominal growth, could either remain at par or even lag in constant or real terms over the next several quarters. This brings us to the most relevant question, what does this imply?

The immediate implications, of course, would be deterioration in most fiscal parameters as it happens in most deflating economies. In the Indian context, this could make the fiscal consolidation path more regressive and public debt dynamics turn adverse. More specifically, meeting the gross fiscal deficit target of 3.9% of GDP in 2015-16 could turn out to be a little more challenging than at present. As illustration, assuming the implicit GDP deflator turns out to zero for 2015-16, that real GDP growth turns out to be at par with the most optimistic growth projection of the Economic Survey, i.e. 8.5%, and that the government sticks to its budgeted expenditure, the gross fiscal deficit would turn out be 4.08% of GDP, or nearly 18 basis points higher. Alternately, if the government were to hold on to its revised fiscal consolidation path to maintain credibility, it would have to cut down expenditure by nearly Rs 25,000 crore unless revenue collections outperform by a similar amount. However, it should also be pointed out that in a deflationary environment, tax revenues too come under pressure; in particular, value based indirect taxes such as central excise (with a few exceptions like petroleum which are specific), service tax and sales tax (state VAT) are more strained.

But we are more concerned about the structural aspects of the unfolding trend in the divergence between CPI and WPI inflation. Our fear is that while macro stabilisation concerns based on CPI inflation have kept monetary policy increasingly tighter, the underlying structural disinflation observed from core-WPI inflation could be hurting the real economy, especially manufacturing. The concern arises from the observation that unlike past behaviour, wherein the gap normally converged with a lag, the two inflation rates have failed to coincide since 2012.
Why is the producer-consumer price gap not coinciding any more? More to the point, what explains the secular decline in core-WPI?

The recent decline in core-WPI is more readily explained by imported deflation via sharp oil and commodity price corrections, about which there is little dispute. But the more relevant issue is if the deflationary trend is exacerbated by weaker domestic demand conditions. Analysts vouching for the “gradual economic recovery” narrative have mostly ignored this trend decline in core-WPI as any reflection of weaker demand upon corporate margins would have been offset by the fall in their input prices. Decelerating bank credit offtake and falling capacity utilisation levels couldn’t quite convince them either. But the sharp decline in corporate profitability, quarter after quarter, could hardly be ignored and has recently been acknowledged by RBI in its June policy statement.

If domestic demand conditions have indeed been weaker, then why has CPI-core inflation reversed? The answer could lie in the several structural rigidity in the supply chain that concentrate pricing power in the hands of retailers. While switching over to CPI inflation as the nominal anchor to guide the new monetary policy framework, it was hoped that policy initiatives by the government should quickly remove these bottlenecks and allow economic agents to respond efficiently to changes in demand conditions. The increasing divergence between WPI and CPI, especially their respective core inflation rates, indicate that the impact of government policy efforts, if any, has at best been marginal.

Or else, how would one explain a reversal in CPI inflation in the face of decline in overall capacity utilisation in the economy!

This also leaves one worried if RBI’s efforts to condition inflationary expectations as per its medium-term glide path by increasingly tighter monetary policy would further compress domestic demand and, therefore, keep WPI inflation in a prolonged disinflationary mode. In which case, the fiscal consolidation path could become more challenging while output cost or trade-off becomes more visible. More to the point, by abandoning the middle path that gave due importance to both consumer and producer inflation indicators in a structurally riddled economy, have we invited more uncertainties in the overall management of the economy then we had initially bargained for?