Here’s How Bad the GDP Number Could Get After Note Ban...

The short-term economic impact of Narendra Modi’s demonetisation move is likely to be negative.

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There is a general consensus that despite the anticipated long-term positives of the currency exchange, branded as demonetisation, the short-term economic impact is likely to be negative.

Just how low did growth in India's gross domestic product (GDP) get in the third quarter of financial year 2016-17?

By extension, what would growth be for the second half of financial year 2016-17?

Among the fifty most prominent economies around the world – including the G20 and the BRICS – India and China have not slipped into GDP contraction even for a single quarter in the last 25 years.

At least half of these fifty nations – including the United States, Germany, Brazil and South Africa – have experienced at least three instances of negative growth during this period.

India's lowest real GDP growth in the last twenty five years was 1.05 percent in 1991.

Solvent, But Not Liquid

What India has undergone since 8 November 2016 is a self-imposed liquidity shock combined with spending austerity. There is no global parallel to India’s situation. India had no fiscal crisis (like Greece and Italy in 2010-12); foreign currency shock (East Asia crisis of 1997-98); banking crisis (the United States in 2008). In each of these, the countries' real GDP shrank by anywhere from 2.8 percent to as much as 13 percent.

The Q3FY17 growth number is very important because it may represent somewhat of a floor or a benchmark to what the Indian economy looks like during a stressful domestic shock. 4.9 percent growth clocked in the Q4FY01 was the lowest quarterly nominal GDP growth in India since 1991.

This article focuses on estimating a range of values for GDP growth in Q3FY17, based on some transparent assumptions.

Deconstructing The Growth Numbers

Real GDP is an inflation-adjusted measure that reflects the value of all goods and services produced by an economy in a given period.

Ideally, one should first forecast the nominal GDP, which is directly estimated based on existing prices, and then take a view of future inflation. Adjust the nominal GDP with inflation, and we arrive at the real GDP.

Be wary of those who jump to predicting real GDP growth without sharing their estimates of nominal GDP and inflation.

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The GDP estimate is the sum of private final consumption expenditure (PFCE), government final consumption expenditure (GFCE), gross fixed capital formation (GFCF) and net exports. The most important driver of India’s GDP is PFCE.

India being a net importer, the net export has a negative contribution to the GDP.

Data Till Demonetisation

Nominal GDP growth hit a low of 6.4 percent in Q2FY16. It revived and reached 12 percent in Q2FY17, a level last seen in Q4FY14.

The uptick in GDP growth coincided with the revival of private final consumption expenditure. This is hardly surprising, since for the last sixteen years PFCE growth (market prices) has a correlation of 0.66 with nominal GDP.

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Before going further with PFCE, let’s focus on the smaller components – government final consumption expenditure and gross fixed capital formation.

Capital Formation

The formation of new capital assets in the economy, represented by GFCF, has been falling since Q3FY13. Data from the Centre for Monitoring Indian Economy shows that the value of investment proposals in Q3FY17 is approximately half of the average value of investment proposals in the previous nine quarters.

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There’s nothing to suggest that the de-growth in GFCF observed since Q4FY16 will be checked in Q3FY17. It may be optimistic to consider that it would return to growth by even the January to March quarter.

Government Spending

The government final consumption expenditure formed a higher than usual portion of the nominal GDP in H1FY17, clocking growth in excess of 20 percent.

But keep in mind that government spending up to 30 November 2016 has reached 86 percent of the fiscal deficit target for the full financial year.

Government spending in second half of the financial year is likely to be constrained, as has been the case in at least three of the previous four years. Whenever the GFCE growth has been upward of 15-20 percent in first half of the financial year, in the second half it tends to nose-dive.

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The exception was FY16, where the GFCE growth was spread out evenly over four quarters. Assuming that the government will stick to its fiscal deficit target by the end of the financial year, GFCE growth is unlikely to grow by more than 6-8 percent.

Private Spending

The lowest quarterly private final consumption expenditure growth for India has been 2 percent in the second quarter of the financial year 1999-2000.

PFCE has been the only component that has never dipped into the negative since financial year 1999-2000. The question is, will PFCE show a de-growth in Q3FY17?

Let's answer this anecdotally. How many households can say that spending from 9 November – the day after prime minister Modi's announcement – to 31 December, was higher than the corresponding period in the last financial year? For households with employment in the unorganised sector, spending is likely to have been lower.

What Could Q3 And Q4 GDP Look Like?

Assuming that the importance of the components remain broadly unchanged and assuming – optimistically – that contribution of net export is zero, one may project a range of GDP values for Q3FY17 based on the arguments already established.

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Discounting the optimistic and pessimistic scenarios we just laid out as the extreme ends of the curve, the nominal GDP growth for Q3FY17 may range between 1 percent and 4.5 percent.

If this self-imposed shock turns out to be somewhat cosmetic, we could expect the economy to start crawling back to ‘normal’ growth from Q4FY17. With that bounce back, the nominal GDP may grow by 6-7 percent.

If inflation for this period remains marginally positive around 1-2 percent, then the real GDP growth for the second half of this financial year is likely to be in the range of 2 percent to 5 percent.

The Long Wait

The first estimates of Q3FY17 GDP will be released in February 2017, and those numbers may well be much higher than the ones discussed here. Early estimates of GDP have a significant dependence on regression/model estimates, based on data from previous periods.

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This would be a flawed approach as the previous period had no liquidity or spending shock, and we will need to wait for the revised estimates. Those will be released only in January 2018. Imagine waiting for a year to get a realistic estimate of the economic impact of demonetisation!

Deep Narayan Mukherjee is a financial services professional and visiting faculty of finance at IIM Calcutta. The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.)