Tag: gdp

Revisiting fundamentals of GDP growth

In light of the ongoing Takshashila-Hudson conference on Shaping India’s Growth Agenda, it is instructive to revisit some fundamentals of GDP and GDP growth.

  • Real GDP grows when there is more economic activity in the region in this time period compared to the last time period (the “real” aspect of GDP growth means that growth due to changes in price levels is stripped out)
  • We can have more economic activity in two ways – we can have more of existing economic activities, or when new economic activities get created
  • An example of the former (increase in economic activities) is if say the production and consumption of mangoes in India rises from 100 units last year to 110 units this year. This implies that there is an increase in the economic activity of production and consumption of mangoes
  • In terms of new economic activities, I will take the example of my own business of quantitative management consulting – I help companies use data and quantitative methods to improve their business. I’m providing a service which (say) didn’t exist previously. Thanks to my services, my clients can improve the quality of their business, and their gains from these improvements are more than my fees. Thus my services have resulted in more economic activity
  • Every time a policy is proposed that is supposed to “increase GDP”, ask yourself how it will actually result in an increase in GDP – whether it aids more economic activity in existing goods and services or if it supports the growth of new economic activities
  • Taxation results in increased clearing price and decreased clearing quantity (Econ 101).
    The effect of tax/transaction cost on clearing price and quantity

    Once can argue that a reduction in taxes can thus foster greater economic activity. However, it must be remembered that taxation is what funds the government. Hence it is not prudent to reduce taxes too much

  • Decrease in transaction cost (cost paid by buyer but that doesn’t go to seller) leads to increased quantity of economic activity (it works exactly the same way as the tax graph above). Decrease in transaction cost is usually Pareto optimal. Any measures that decrease transaction costs can help foster greater economic activity
  • Transaction costs can occur due to multiple ways. In commodity (including food) markets, they can be seen in terms of a high bid-ask spread. Transaction cost, however, is not necessarily monetary. If you need to travel for a transaction, that is transaction cost. If you have to stand in line to buy something, the time spent again is transaction cost. Time spent by goods waiting for customs or octroi clearance is transaction cost
  • Focusing on eliminating transaction costs is a sure fire way to spur economic growth. This is why measures such as the GST (which cuts waiting time of goods at inter-state borders, among other things) are important
  • It is also important to take measures that allow entrepreneurs to take risks and try and create new classes of goods and services which were hitherto not traded. Thus we need policies that reduce the cost (monetary and otherwise) of starting a business. This includes the time taken to set up a business. This also includes policies that allow an unsuccessful business to be wound up quickly so that the capital and labour hitherto employed can be more profitably employed elsewhere

I can go on (and I realize I’ve gone beyond fundamentals here), but I think this does enough to set the agenda for today’s discussions, so I’ll stop here. Just one last thing – a phrase that is likely to be bandied about a fair bit in today’s conference is “this measure can add X% to the GDP”. Whenever someone says that you need to ask the question of whether it is a one time increase in the GDP or if it can lead to a sustainable increase in GDP growth (that’s the “resident quant” bit for this blog post).

Compounding and Foreign Policy

In today’s Business Standard, Nitin Pai writes about something he’s mentioned a few times before – that India’s best China/Pakistan/US policy is “8% growth”. Unfortunately a lot of space in his piece talks about appointments in ministries and cabinet formation, and he doesn’t directly touch upon why 8% growth is a viable foreign policy (it is possible he had mentioned this but got edited away).

There are two primary reasons why strong economic growth makes for good foreign policy. Firstly, a fast growing economy means that others will want to get their share in it. If you are growing at a rate much higher than the other big economies, other countries will want to piggyback on your growth. They will want to trade with India, invest in India and  get India to invest in their respective countries. And for any of this to happen, the foreign country will need to have an overall good relationship with India – if they piss off India, they can get left out of partaking in India’s economic growth. And that will ensure good foreign relations.

The second reason has to do with compounding. Assuming that India can afford to spend only a fixed percent of its tax revenues on defence (being a democracy, the government will always have commitments towards welfare and infrastructure spending which cannot be touched), and assuming that taxes as a proportion of GDP are constant, this means that India’s defence spending is likely to be proportional to the GDP.

With 8% growth, India’s real GDP expected to double in about 9 years’ time. Or, our defence budget can double in 9 years’ time. With only about 5% growth (as we have now), in 9 years our GDP, and consequently our defence budget, will only increase by 50%! That is the power of compounding, and that shows you how increased economic growth can lead to greater defence spending, by keeping proportion of defence spending constant!

Accuracy of GDP Numbers

Earlier today on Twitter, RahulRG pointed out a research report by Credit Suisse analysts Neelkanth Mishra and Ravi Shankar which talks about India’s massive informal economy. The report says that by nature the informal economy cannot be measured, because of which our estimates of GDP may not be accurate. The analysts point out that every time we move to a new series of GDP (we last did so in 2004, and are likely to do so again shortly), there is an upward revision in the GDP for the preceding series, which they attribute to underestimation of the contribution of the informal sector.

While these numbers are likely to get fixed when we move to a new series, what I’m concerned about is what this uncertainty in GDP estimation means with respect to the GDP growth rate, since that is the one number that analysts of all hues track when trying to understand how the country is doing. For example, if you google around you will see analysts arguing about whether India’s GDP growth in the next quarter will be 4.7% or 4.8%. Before we settle to argue on such minutae, I argue, we first need to understand the possible uncertainty in GDP estimates.

In order to estimate the impact of uncertainty of the GDP calculation on uncertainty in GDP growth, I did what I know best – a simulation. For different levels of accuracy, I calculated the range that the actual GDP growth can take. The results are presented in the following table. The first column in the table refers to the accuracy of the GDP estimate at the 95% confidence level. That is, if the first column shows 1%, it means that if the GDP is estimated to be 100, the “true” value of the GDP will be between 99 and 101 95% of the time.

Error True GDP Growth Rate
5% 6% 7% 8%
0.05% 4.93-5.07 5.93-6.07 6.92-7.08 7.92-8.08
0.1% 4.85-5.15 5.85-6.15 6.85-7.15 7.85-8.15
0.2% 4.7-5.3 5.7-6.3 6.7-7.3 7.69-8.31
0.5% 4.26-5.74 5.26-6.75 6.25-7.76 7.24-8.77
1% 3.54-6.49 4.51-7.52 5.5-8.52 6.48-9.53
2% 2.09-8.03 3.03-9.02 4-10.05 4.98-11.13

Notice that even if the measurement of the actual GDP is accurate up to 0.05% (or 5 basis points), we can estimate the growth in GDP only up to an accuracy of 15 basis points! So arguing whether the GDP growth will be 4.7% or 4.8% is, in my opinion, moot! Unless our statisticians can say that the accuracy in measurement of the GDP is within 5 basis points that is!

PS: Also read Neelkanth Mishra’s excellent op-ed in the Indian Express on India’s informal economy.

What should we do about the falling rupee?

So the more perceptive of you would have realized that the rupee is falling. And fast. At the beginning of the year, fifty four rupees bought a dollar. Now you need over sixty rupees. That’s a fall of over ten percent in half a year.

People argue based on differences in interest rates and interest levels between India and the United States, and India’s current account deficit, that the rupee deserves to depreciate. Some argue that the rupee should actually trade even lower. That is correct. What makes the fall of the rupee worrying, however, is that it has happened so quickly. No theories on trade imbalance or rates imbalance or inflation can account for the fall of ten per cent in half a year.

The issue, of course as everyone knows, is to do with capital flows. While India has run a persistent current account deficit, the continuous inflow of foreign investment into the Indian markets (either direct or indirect) had ensured that the rupee was relatively stable over the years. With India maintaining a high growth rate in the GDP over the noughties, the inflow was persistent. Things aren’t so good now, however.

India’s GDP is slated to increase at a paltry 5% this financial year. The growth story is seemingly over. And that is not all. Things aren’t looking great in other parts of the world also. Due to this concept of margin financing, sometimes when some of your holdings lose value, you are forced to liquidate other holdings in order to comply with “margin requirements” (we will not go into the technical details here). So with markets around the world not doing great, and India’s growth not as spectacular as it used to be, and with the country’s muddled policies (check out how difficult the government has actually made it to invest in India – irrespective of your nationality), investors started exiting. With some investors exiting, asset values dropped and the rupee dropped. Consequently other investors exited. And so forth. It did not help that there was nothing inherent in India’s government policies to hold them here.

So that’s the story so far. Question is what we should do going forward. As I mentioned earlier, there are two levers that can help shore up the rupee – the capital account and the current account. Within the current account there are two components – imports and exports. What normally happens when a currency depreciates is that exports become more competitive and go up further. Imports become costlier and thus reduce. On the current account front, thus, we have what is called as “negative feedback”.

Notice that in the past whenever an economy staged a recovery, it was generally preceded by a devaluation of the local currency. So since our currency is already devalued the stage is set for recovery, right? Unfortunately it’s not so simple. While it is true that our exports are now likely to be more competitive, fact is that Indian industry is not well placed to capitalize on that. Investment bottlenecks, labour laws and bureaucracy means our entrepreneurs haven’t been able to move fast enough to take advantage of the falling rupee and up exports. This can be borne in the fact that the Reserve Bank of India, which normally shies away from controlling exchange rates (as long as they are not too volatile), has issued several public statements on this matter in the recent past, and taken steps to prevent further fall in the currency levels. That the Central Bank has had to step in to protect the currency shows that we are in extraordinary times. The natural corrector to a falling exchange rate (increase in exports) is absent.

Matters are not helped, of course, by the fact that one of our largest imports is an asset – gold. Thing with asset prices is that unlike prices of “normal goods”, the demand for assets increases with price. When asset prices increase, people see “momentum” in the asset and want to get on to the bandwagon. So there goes part of another natural corrector to a falling exchange rate (less competitive imports).

So coming back to where we started off with – what should the Government do? While this is going to be a time-consuming process, what the government needs to do is to ensure that exporters can exploit the falling rupee. Reforms in this direction are not easy of course – since they require significant efforts in removing bureaucracy and making it easier to do business – which means we need significant administrative reform. There is also the small matter of possibly having to reform labour laws (while on the matter of labour laws, check out this paper by Takshashila Scholar Hemal Shah, who presents some easily implementable reforms in the labour law). While these are difficult things to implement, the fact that there is a crisis gives the government an alibi to push ahead with the reforms. PV Narasimha Rao had done that once in 1991. The problem now is that the government may not have political will given that elections are less than a year away. In this context, it would be advantageous to have early elections, for a new government with a fresh mandate might be more prone to taking tough short-term measures.

Currently, the government is trying its best to shore up on the other levers. Gold import is being curbed – except that it will be hard to implement since they will simply get diverted to the black market. The Finance Minister is traveling the world putting up a roadshow to get investments to India. That, however, is akin to putting lipstick on a pig since there is little in India’s fundamentals and current economic scenario to attract foreign investors. Even if some of these measures succeed, they will only lead to temporary respite to the currency. Fact is that for sustainable improvement in currency, tough reforms are mandatory.