31st October 2020

Confidant Classes

A Premier Judicial Service Coaching

GDP contraction decoded

Although most people expect India’s GDP to experience a substantial contraction when the Ministry of Statistics and Program Implementation (MoSPI) released first quarter data on Monday (April, May , June) of the current fiscal year, the general consensus was that the decrease would not exceed 20%.

It turns out that GDP contracted 24% percent in the first quarter. In other words, the total value of goods and services produced in India in April, May and June of this year is 24% lower than the total value of goods and services produced in India in the same three months of the year last year.

Almost all of the main economic growth indicators, be it cement production or steel consumption, show a sharp contraction. Even the total number of telephone subscribers contracted this quarter. What’s worse is that due to widespread crashes, the data quality is suboptimal and most observers expect this number to worsen when revised in a timely manner.

What is the biggest implication?

With GDP contracting more than expected by most observers, it is now believed that full annual GDP could deteriorate as well. A fairly conservative estimate would be a contraction of 7% for the full year. Figure 1 puts this in perspective. Since economic liberalization in the early 1990s, the Indian economy has recorded an average GDP growth of 7% each year. This year it is likely to turn into a turtle and decrease by 7%.

In terms of gross value added (an indicator of production and income) by different sectors of the economy, the data shows that, with the exception of agriculture, where GVA increased by 3.4%, all other sectors of the economy have seen your income drop.

The most affected were construction (–50%), trade, hotels and other services (–47%), manufacturing (–39%) and mining (–23%). It is important to note that these are the sectors that generate the most new jobs in the country. In a scenario where each of these sectors contracts so sharply, i.e. their production and incomes decline, more and more people would lose their jobs (decrease in employment) or not get them. (unemployment increase ).

What are the causes of the contraction in GDP?

Why was the government unable to stop it?

  • In any economy, the total demand for goods and services, that is, GDP, is generated by one of the four growth engines.
  • The most important driver is demand from consumers like you. Let’s call it C, and in the Indian economy it was 56.4% of all GDP before this quarter.
  • The second most important driver is the demand generated by private sector companies. Let’s call it me, and it was 32% of all India’s GDP.
  • The third driver is the demand for goods and services generated by the government. Let’s call it G, and it was 11% of India’s GDP.
  • The final driver is net demand for GDP after subtracting imports from India’s exports. Let’s call it NX. In the case of India, it is the smallest engine and, since India generally imports more than it exports, its effect is negative on GDP.

Then total GDP = C + I + G + NX

Now look at Chart 4. It shows what happened to each of the engines in the first quarter.

  • Private consumption, the biggest driver of the Indian economy, fell 27%. In monetary terms, the decrease is 5.31.803 crore compared to the same quarter last year.
  • The second driver, business investment, fell further: it is half of what it was in the same quarter last year. In monetary terms, the contraction is 5.33,003 million rupees.
  • So the two biggest drivers, which accounted for over 88% of India’s total GDP, experienced a massive contraction in the first quarter.
  • NX or net export demand turned positive in this first quarter as India’s imports fell more than its exports. If, on paper, this boosts overall GDP, it also indicates an economy where economic activity has collapsed.
  • This brings us to the ultimate engine of growth; government. As the data shows, government spending increased by 16%, but this was not close enough to compensate for the loss of demand (energy) in other sectors (engines) of the economy.

Examining the absolute numbers provides a clearer picture. When the demand for C and I fell by Rs 10.64,803 crore, government spending increased only by Rs 68,387 crore. In other words, public spending increased, but it was so low that it could only cover 6% of the total decrease in demand from individuals and companies. The net result is that, although, on paper, the share of public spending in GDP has increased from 11% to 18%, the reality is that total GDP has fallen by 24%. It is the lowest level of absolute GDP that makes the government seem like a bigger growth engine than it is.

What is the exit?

When income falls dramatically, individuals reduce their consumption. When private consumption falls sharply, companies stop investing. Since these two decisions are voluntary, there is no way to force people to spend more and / or force companies to invest more in the current scenario. The same logic also applies to exports and imports.

In these circumstances, there is only one engine that can drive GDP and that is the government (G). Only when the government spends more, either by building roads and bridges and paying salaries, or by distributing money directly, can the economy recover in the short and medium term. If the government does not spend enough, the economy will take time to recover.

What prevents the government from spending more?

Even before the Covid crisis, public finances were overburdened. In other words, it wasn’t just about borrowing, but about borrowing more than you should have. As a result, you don’t have that much money today.

You will have to think of innovative solutions to generate resources. Chart 4 from the McKinsey Global Institute provides ways in which the government can increase an additional 3.5% of GDP.

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