Why The Q2 GDP Data Shows A Surprise Recovery
The economic recovery is good but not broad-based. The sectoral adjustment to the ‘Unlock’ phases is not uniform, writes SK Ghosh.
India’s gross domestic product figures for June-September 2020, released by the Central Statistics Office, have taken all by surprise. Against the market expectation of a GDP contraction in the range of 9-11%, the GDP registered a contraction of 7.5%. At market prices, the contraction was at 4.0%. This was much better than expected. The sequential growth is mostly on the back of agriculture and was on expected lines. Agricultural GDP registered a growth of 3.4%, the same as in April-June but the underlying inflationary pressures are visible in nominal figures.
Multi-Speed Climb Back
Manufacturing has registered a sharp recovery with the sector emerging out of the contraction in Q2FY21, registering a growth of half a percentage point. The jump in manufacturing numbers are even better than Q2FY19, which is unexpected, but a pleasant surprise. Utilities have also registered a sharp recovery as most of the electricity-intensive activities resumed. This trend in electricity consumption was clearly visible in the high-frequency indicators.
The construction activity continues in the contraction mode, but with sharp improvement over Q1 contraction as it registered only an 8.6% decline in Q2 as compared to -50.3% in Q1. The jump in construction sector activities is in variance with seasonal trends, when it always declines in Q2 with the onset of the monsoon session. The unexplained surge in construction activities could possibly be then explained by the continued traction in highway construction.
The recovery in services, notably the non-essential services was quite impressive. Trade, hotels, transport, communication & services related to broadcasting have recovered sharply from the trough of Q1 on the back of progressive opening up of the economy. The rate was -15.6% from -47% in Q1.
The worrying aspect, however, is the financial, real estate and professional services, whose growth has come down in Q2 vis-à-vis Q1.
So, all said and done the recovery in services is slowest in comparison to other sectors.
Overall, the recovery is good but not broad-based. The sectoral adjustment to the “unlock” phases isn’t uniform and displays differential resilience. This remains a matter of concern and if the trend continues the chances of low growth and high inflation are high.
Interestingly, the growth in manufacturing coupled with a growth in the transport sub-segment tells an intriguing story of how India coped with the lockdown in Q1. Manufacturing production was ramped up significantly when the economy opened up after lockdown and there was a surge in goods transport across roads, railways, and aviation. Additionally, the communication sub-segment could have done well clearly reflecting the benefits of working from home. This possibly could explain the smart recovery for the trade sub-segment of the GDP, a fall out of a jump in manufacturing production.
The Demand Picture
On the demand side, the most important concern has somewhat abated. Private consumption has improved in Q2. However, YoY change remains in the negative territory, at -11.3%. The government-fixed capital expenditure growth has plummeted to -22.2%, after a long time. Had this been in positive territory, the GDP numbers would have been even better. The share of private consumption to GDP has nonetheless remained 200 basis points less than Q2 FY20. The imports have been mostly in contraction mode, as oil prices continue to be subdued. Although exports have improved, they’re still growing negatively. Change in stocks has turned positive in Q2 on account of higher inventory, as was widely expected. Going forward, if there is an inventory drawdown, as was the case post-GST implementation, manufacturing growth could be impacted going forward.
Investment demand has improved with the resumption of projects stalled by Covid-19. However, the patchy growth across the sector reflects in domestic demand figures with figures mostly showing modest recovery sequentially. Falling imports and continued contraction in investment suggests poor domestic absorption and intermediate demand.
The reading of Q2 GDP suggests that the output gap has not corrected to the point that it will be a concern for demand-pull inflation. Further, the inflationary pressure in agriculture goods despite expanding output has further capped policy options, as the possibility of inflation is real. The policy option must move towards further easing the mobility of goods and massive thrust to the construction and infrastructure sector. The recent measures are in this direction and should be pursued.
What RBI Needs To Do Next
Overall, with the Q2 contraction being significantly less than expected, the H1 GDP contraction is at -15.7%. With growth prospects improving, the focus now shifts to the next Monetary Policy Committee meeting outcome on Dec 4. We believe the focus should be on ensuring that the system remains in balance, as excessive liquidity conditions have encouraged excessive risk-taking, thereby undermining the financial stability conditions.
The markets have been awash with liquidity as RBI tried to mitigate the damage done by Covid-19 related disruptions. The transient liquidity conditions show that in October, RBI had to inject liquidity in the market through LAF operations. However, in November again transient liquidity turned positive with Net LAF absorption at Rs 5,54,433 crore as of Nov. 26, with an average surplus of Rs 4,16,999 crore so far in the current fiscal. With the rupee showing strength owing to improved external metrics, RBI has an additional source of excess liquidity to manage. It has already accumulated $97.48 billion in forex reserves so far in the current fiscal.
With so much liquidity floating around, and bank credit still on the slow growth trajectory, as a matter of policy, RBI should be directing liquidity flow towards the long-end given the excessive fall in short-end yields. One way of achieving this is by advancing the CRR cut which is expiring on March 27, which would lead to the draining of Rs 1.46 lakh crore from the market. To balance that, RBI should announce a simultaneous open market operations of an equivalent amount. Another possibility could be allowing mutual funds to participate in reverse repo in conjunction with a Standing Deposit Facility so that a floor is established. RBI can also introduce a Market Stabilization Scheme as was done earlier in times of excess liquidity conditions during demonetisation. With inflation not going down significantly and excess liquidity in the system, RBI has to pursue active liquidity management to help the economy from overcoming the liquidity trap.
Overall, the Q2 GDP numbers have reignited a debate: can we afford a continued bout of inflation in search of that elusive growth, which now seems nearer—based on today’s numbers—rather than being too far?
Soumya Kanti Ghosh is the Group Chief Economic Advisor at State Bank of India. Views are personal.
The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.