Inflation And The Nominal Illusion
→ In times of accelerating inflation, nominal variables have little informational value about underlying real quantities. Therefore, even as markets and analysts cheer the nominal buoyancy, the challenge for policymakers will be to separate the signal from the noise.
India’s economy continues to recover from the pandemic even as the Russia-Ukraine conflict has thrown up new challenges. Like other emerging markets, however, activity remains below the pre-pandemic path. For example, if the financial year 2021-22 or FY22 gross domestic product growth comes in close to our expectations of 8.7%, the level of India’s GDP will still be about 6-7% below its pre-pandemic path.
At the same time, however, several high-frequency variables have scaled new highs. Both exports and imports of goods clocked record levels in FY22. Similarly, monthly GST collections have averaged Rs. 1.4 lakh crore in the January-March 2022 quarter versus Rs 1.1 lakh crore in the same quarter of 2020. On its part, credit growth has accelerated to double digits in April 2022, for the first time since August 2019.
Does all this give rise to an ostensible puzzle? Why the apparent disconnect between GDP and the higher buoyancy of exports, imports, indirect taxes, and credit growth?
That 70s Show
To resolve the puzzle, however, one has to simply appreciate how elevated inflation is around the world and the perils of comparing nominal and real variables during such times.
Global Consumer Price Index prices increased 1.2% in March, easily the fastest monthly increase in almost three decades. More generally, global CPI is tracking a 10% annualised momentum in the first quarter of 2022, even before the full impact of the energy and food shock from the Russia-Ukraine conflict has been absorbed. Meanwhile, the increase in commodity prices – more germane to judge the performance of several emerging market exports – is even more dramatic. Crude prices, global food prices, and commodity prices, more generally, are all up between 30-40% between FY20 and FY22.
India is witnessing its share of inflation. Even as CPI inflation has averaged almost 6% YoY over the last six months, Wholesale Price Index inflation has averaged almost 13% over the last year.
Consequently, India’s GDP deflator, the broadest measure of prices in the economy, has grown 10% between FY21 and FY22 – the most growth since the new GDP series came into effect in 2011-12.
As a consequence, the level of the GDP deflator in January-March was 20% over January-March 2020 levels.
In periods like this, nominal variables have little informational value about the underlying volume or value-added growth, and the imperative to appropriately deflate them is even greater. Failure to do so can give rise to a ‘nominal illusion’, generating the wrong signals on the true state of the underlying business cycle and therefore confusing the policy response.
GDP: A Tale Of Two Paths
This is best seen in the divergence between India’s nominal and real GDP paths. Strong growth of the GDP deflator has meant India’s nominal GDP is expected to surge almost 20% in FY22 – the highest in a decade and twice the 5-year average of 10%. Consequently, nominal GDP was already about 5% above its pre-pandemic path by March 2022. Assuming the RBI’s FY23 GDP forecast of 7.2% fructifies and even making relatively conservative assumptions on inflation, nominal GDP in FY23 can be expected to rise another 13-14%, such that it will be a full 7% above its pre-pandemic path by March 2023.
Meanwhile, the level of real GDP is currently about 6-7% below its pre-pandemic path and if FY23 growth tracks the RBI’s forecast, the undershoot will remain in that range by March 2023.
Exports: Relative Outperformance But Also Large Price Effects
Exports are a case in point. Nominal export growth has been very impressive, with merchandise exports growing 32% in FY22 over FY20. However, because this was also a period in which global inflation and commodity prices surged, it’s important to separate price from volume effects. GDP data allows us to make that distinction. Nominal export growth for the four quarters of the calendar year 2021 (which cover both goods and services) reveals an impressive 24% growth over 2019. But the exports deflator has also grown 17% during that period, such that the underlying real growth of exports in GDP data is more moderate at 5.5%.
To be sure, exports are still – relatively – among the best performing sectors on the demand side. Even as GDP has grown 1.2% between 2021 and 2019 (calendar year), private consumption by 1.2%, and fixed investment by 2.2%, exports grew 5.5% across those years. Consequently, exports/GDP rose to almost 21% in 2021 from 19.5% in 2019.
The limited point, however, is that nominal growth overstates the buoyancy because of elevated dollar inflation. Appropriately, deflating prices is therefore key to understanding the relative performance of different export sectors.
Furthermore, with global growth under some pressure on account of the Russia-Ukraine conflict, volume growth could face some headwinds in 2022. Consequently, a sustained emphasis on increasing global market share by increasing domestic competitiveness will need to continue. It’s undoubtedly true that rising export unit prices are welcome because they represent a positive terms-of-trade impulse to the economy but, taken more holistically, India, as a net commodity importer, gets adversely impacted by higher commodity prices.
GST And Credit Growth: Discernible Price Effects
Exports apart, the buoyancy of some other nominal variables such as GST collections and credit growth has also benefited from discernable price effects and therefore need to be interpreted carefully.
Consequently, the ratio of GST-to-GDP has been broadly stable over the last two years, even as it has inched up in recent quarters.
However, at least two caveats are in order on the tax front:
GST collections are undoubtedly benefitting from improved compliance as input tax credit leakages are progressively plugged. This is unambiguously positive but needs to be complemented with a simpler rate regime and broader base to realise GST’s full promise.
Even as GST-to-GDP ratio remains stable, direct taxes-to-GDP ratio has increased meaningfully, from 5.2% of GDP in FY20 to 5.7% of GDP in FY22, likely reflecting an increased formalisation of the economy during the pandemic, and very encouraging from a tax revenue perspective going forward.
Does Inflation Take The Credit?
On its part, bank credit growth slowed sharply in 2019 and 2020, bottoming around 5.5% towards the end of 2020. Since then credit growth has been progressively accelerating to touch about 11% in April, raising hopes of an investment revival. However, the pick-up needs to be interpreted carefully because the acceleration has coincided with a sharp pick-up in the GDP deflator. Is stronger credit growth reflecting an acceleration in activity and investment or simply higher working capital requirements on account of higher inflation? To distinguish between these hypotheses, it’s important to deflate nominal credit to assess the evolution of real credit.
Indeed, as the next chart reveals, even as nominal credit has accelerated, real credit growth – though having bottomed – still remains relatively muted and below pre-pandemic growth rates.
A more sustainable pick-up in demand will therefore likely be required to trigger a sustained pick-up in real credit growth.
What Do Buoyant Imports Imply?
In contrast to some of the other high-frequency data, the buoyancy in imports appears more real. Nominal imports grew 21% in 2021 over 2019. But even after stripping out prices, imports have grown almost 11% in real terms. Consequently, real imports were at 126% of pre-pandemic levels in October-December 2021, easily the best-performing on the demand side.
What does the strength of real imports tell us?
First, the domestic demand is stronger than the signals emitted by the more muted domestic industrial production data suggest. Domestic production of consumer goods remains at just 97% of pre-pandemic levels as recently as February in the IP data. In contrast, GDP data reveals private consumption was already at 107% of pre-pandemic levels in October-December 2021 (though still below the pre-pandemic trend). With services lagging goods, the latter can be expected to be even higher than 107%, creating a big gulf between demand and production.
This gulf is explained by strong import growth. The good news, therefore, is that domestic consumption may not be as weak as IP suggests. The concern is that consumption demand may be leaking into imports. Could it be because the distribution of consumption has skewed towards the rich during the pandemic, whose consumption basket is more import intensive? Could it be that domestic SME supply chains have been impacted during the pandemic, triggering greater imports? More data will be required to discern among these hypotheses.
Second, the relative strength of imports – vis-à-vis exports – is widening the underlying trade deficit. This is best seen by constructing a ‘real’ trade deficit of goods and services using deflated imports and exports from GDP data. This measure (proxying for volumes) has trended wider in recent years, revealing the recent widening of the current account is not just reflecting the negative terms of trade effects of higher commodity prices, but also a growing gulf between underlying import and export volumes.
Saving Grace: Inflation And The Debt Overhang
The one area where higher nominal GDP growth on account of higher inflation is helping is debt dynamics. India’s debt/GDP surged from 72% before the pandemic to about 89% by March 2021. However, with almost 20% nominal GDP growth in FY22 followed by 14% in FY23, debt/GDP is expected to gap down towards 82 % by March 2023. In contrast, if the GDP deflator had remained at its pre-pandemic average (3.2%) debt/GDP would have stabilised closer to 90% (the counterfactual). As we have been emphasising, while both the evolution of nominal GDP growth and a reduction in the primary deficit are key to debt sustainability, the evolution of nominal GDP growth has a disproportionate impact vis-à-vis the exact pace of fiscal consolidation, given India’s starting points.
But’s Let Not Draw The Wrong Lessons
What this should not suggest, however, is that debt can be successfully inflated away. As history has consistently revealed, such an approach is fraught with danger and quickly turns counter-productive, because the macroeconomic uncertainty that elevated inflation triggers ends up hurting medium-term real growth, and thereby debt dynamics. Furthermore, to the extent that monetary policy is forced to respond to higher inflation, real interest rates will have to rise thereby adversely impacting the ‘r-g’ differential, and further impinging on debt dynamics.
Therefore even as nominal GDP growth is key to debt dynamics, it needs to be achieved at the altar of higher real GDP growth, not an acceptance of higher inflation.
What Does All This Mean For Policy?
Disentangling how much of the buoyancy in nominal variables is on account of inflation versus growth of volumes is key to calibrating policy appropriately. Given sticky and elevated inflation, monetary policy will have to focus predominantly on inflation management, explaining the RBI’s renewed emphasis on inflation management last week. Meanwhile, given the relatively moderate growth of real variables, fiscal policy will have to continue giving growth a helping hand. Focusing on infrastructure and public investment, as authorities have done, is the appropriate thing to do, given the growth multipliers and job-creating nature of that spending.
The risk, however, is that capex spending gets crowded out by higher food and fertiliser subsidies, an eventuality that policymakers must carefully guard against.
To protect against this, more revenue buffers will be required, particularly through asset sales and disinvestment. Finally, the trend deterioration of the underlying real trade deficit suggests a role for a real depreciation of the Rupee to trigger the necessary expenditure switching and help narrow external imbalances, even as fiscal and monetary policy are freed up to manage domestic growth-inflation dynamics.
All told, in times of accelerating inflation, nominal variables have little informational value about underlying real values and growth dynamics. Therefore even as markets and analysts cheer the nominal buoyancy, the challenge for policymakers will be to separate the signal from the noise.
Sajjid Z Chinoy is Chief India Economist for JPMorgan. All views are personal.
The views expressed here are those of the author and do not necessarily represent the views of BQ Prime or its editorial team.