Recovery to start in October, says economist, who accurately predicted slower Q1

Hugo Erken, senior economist at Rabobank’s RaboResearch Global Economics & Markets, had accurately predicted India’s first quarter gross domestic product (GDP) would decelerate to 5.7%. In an email interview, Netherlands-based Mr. Erken, who is also the firm’s country analyst for North America, Mexico and India, discusses what drove his forecast and the way forward for India. Excerpts:

What factors drove your predictions?

In my Q1 forecasts, two important factors drove its accuracy. First, we expected private consumption to be well below trend growth due to demonetisation. Second, growth of bank loans has been negative for three subsequent quarters and I received signals from India that companies have been very reluctant to invest. So, ultimately, the contribution of private investment was very subdued.

You have used the NiGEM model of forecasting. Can you explain the model?

At Rabobank, we use different tools for forecasting. First, NiGEM is an econometric world trade model, which is the leading instrument for our economic forecasts. There are two major benefits in using NiGEM.

First, it ensures that global trade flows add up and possible economic shocks in other countries are accounted for.

If, hypothetically, India’s most important trading partner, the U.S., would face a crisis or implement trade barriers and this leads to lower imports, it directly affects Indian exports and thus the economy.

Second, NiGEM is an error-correction model, which ensures that short-term deviations of GDP from a country’s growth potential are made up eventually. Ultimately, growth is driven by structural capital formation, structural employment and labour-augmented technological change. Using NiGEM has its upsides, but one can’t solely rely on it. It doesn’t take into account, for instance, demonetisation or GST. So, we use satellite models to break down and forecast expenditure components of GDP.

India moved to a new GDP series. Many questioned the methodology when it showed high growth. But now there is concern around the fall.

It is comforting to see that the Central Statistics Office is continuously improving their methodology to produce statistics. Moreover, I’m not the one to criticise the CSO, as I’m not a statistician, so I’m a bit reluctant to say too much about this.

However, it is well known that before the revision in 2015, GDP data was biased as the factor used to scale up the information collected from the sample of firms was unreliable due to the large number of shell firms.

The MCA database is supposed to produce better corporate sector data. However, there are still some worries about the scaling factor the CSO uses. In 2016, two India researchers, Nagaraj and Srinivasan, said that the number of firms in the MCA was the actual number of firms and no scaling was needed. By using a scale factor on top of registered companies, the private sector is again overstated.

Second, there are some doubts about measurement of the informal economy, which is proxied by the CSO.

If the informal economy is not correctly represented in the national accounts, one would suspect even more pain from demonetisation than the national account data reveals, as the informal sector is much more cash based. For now, we believe that the CSO is producing statistics at the best of its abilities and are comfortable with these data.

Your views on the RBI stating that 99% of demonetised notes had returned to the system?

This would suggest that the government failed to purge black economy in the economy. However, we feel that it is far too early to draw conclusions about the failure or success of demonetisation. First, the Finance Minister said that a lot of people that had handed in deposits are still being questioned. It is interesting to see the outcome of these investigations. And, demonetisation served several goals, one of which was to lower the velocity of cash in the economy and pull a part of the untaxable informal into formal territory. We still have to wait and see what money velocity will eventually will turn out to be. And, we still have limited data about post-demonetisation tax revenues.

You have predicted that growth would be slower at 5.9-6% in Q2 and accelerate to 8% in Q3.What will change?

In Q2, we think especially the GST roll-out will weigh on growth. Sentiment indicators in July collapsed (and did rebound in August), with the manufacturing PMI declining to 47.9 from 50.9 in June and the services PMI dropping from 53.1 to 45.9. Many analysts regard this July slowdown as transitory, reflecting mostly initial adjustment costs for small firms in particular. However, our take is that we’ll also see GST disruptions beyond July — a result of stalling working capital cycles and systemic failures to seize tax credits caused by incomplete digital tax filings by firms, starting in September.

The flooding in India, including the Mumbai area, will have an effect on economic activity as well. In comparison, the severe Mumbai flooding in 2005 resulted in an estimated damage of $1billion.

For Q3 and Q4, after the GST and demonetisation pain peter out, we expect the Indian economy to recover and even see faster than trend growth on the back of higher private consumption spending and recovering private investment. Moreover, government investment in infrastructure will continue to support growth. Ultimately, we expect India’s growth potential to lie somewhere around 8%.Of course, to reap full benefits of India’s growth potential, the government needs to continue to play an important role in reforming the economy. Challenges are improvements of the education system, reforms of the labour market, land acquisition reforms and fighting pollution.

There are two different pictures on the Indian growth story. One the stock market seems to be doing well and foreign investors have been pumping money. On the other hand, tax collections have been decent, but at the ground level people feel there is slowdown. Why in your view such a different picture is emerging?

It is difficult for me to provide an explanation for this, but perhaps investors look at the fundamentals of the Indian economy and look through the short-term impact of GST and demonetisation, something which is of course significantly felt by the Indian people on the ground. After the demonetisation and GST dust will settle, India has enormous growth potential and this perhaps explains why investors are generally bullish on India. Moreover, there is significant progress that has been booked with the Made in India campaign. Moreover, due to continuing wage increases in China and fairly liberalised capital markets, I expect more and more focus on India as a primary manufacturing hub. This is already shown in several announcements by large car manufacturers to relocate of initiate production facilities in India.

What are the key factors you think which is going to drive growth. Your views on the reforms undertaken by the government?

After several years of transition as an emerging market, the challenge for India in the long run will be to avoid the so-called middle income trap. This is the hypothetical threshold of threshold lies between $12,000 and $18,000 per capita, after which growth slows significantly. Growth slows because the emerging market loses its comparative cost advantage, as wages tend to increase with rising levels of prosperity. The middle income trap is visible in many emerging markets, such as Brazil, Mexico and Thailand. Countries that were above to dodge the middle income trap are for instance South Korea, Japan and Ireland. This was done by large-scale investment in education, a proper knowledge to foster innovation and internalize knowledge developed abroad and enhancing the broad institutional context. The role of the government in orchestrating a successful transition will be key. So far, the government has been able to push reforms deemed impossible a couple of years ago, such as fighting corruption and reforms of the tax system (GST). So, in this sense, the Modi administration has been doing a good job in providing initial steps towards framework conditions that are ultimately necessary to bridge the middle income trap. But, as said, there are a lot of policy steps to still be taken. Moreover, the current deadlock in the Upper House is not ideal to push ahead with an ambitious policy agenda, so perhaps after 2022 things will go smoother.