Macroeconomic backdrop to the 2016 budget

Business Standard, 22 February 2016

In understanding the coming Budget announcements, we need to have a backdrop of economic conditions. While GDP data is the subject of debate, there is no disagreement on what we see with the nominal results of listed companies. The results for October-December 2015 show a difficult situation. Recessionary conditions are visible in sales growth and profit margins. Interest payments continue to grow faster than sales or profits, giving a worsening of credit stress. These conditions are a call to arms for reforms.

Two important components of demand in India are investment and exports. Many people are aware that the CMIE projects data shows only slight gains compared with the bottom. What has not been as widely noticed are the difficulties in exports. Using quarterly firm data, we construct an index of exports of non-financial non-oil companies. This avoids the fluctuations in exports of petroleum products, and pulls together exports of goods and services. The index series runs from 1999 onwards. Firms observed in each of two consecutive quarters are used to estimate the percentage change over that quarter. The index is seasonally adjusted.

The calculations show a dramatic decline in recent quarters. Exports, measured in nominal rupees, are now back to the value seen in 2011, which is not much above that seen in 2008. Stalling of exports growth over a seven year horizon is unusual in the post-1991 period.

Difficulties with investment demand and export demand have adversely affected top line growth. The annualised growth rate of seasonally adjusted net sales, in nominal rupees, for the Oct-Dec 2015 quarter was -6.29%. The more familiar year-on-year growth shows a value of -0.42%. In the past, nominal sales growth on a year-on-year basis has yielded near-zero values in the recessions of 2001 and 2009.

The index of operating profit shows no expansion in nominal terms after 2012, where the present recession began. The overall operating profit margin is at 17%, which is similar to the values seen in the recessions of 2001 and 2009. In good times, in India, we get an aggregate operating profit margin for non-finance non-oil companies of 20% to 25%.

While operating profit growth and sales growth have experienced difficulties, interest payments have grown steadily. In every quarter after 2009, interest payments have grown by over 7%, but in most quarters, sales or operating profits have grown by less than 7%. A comparison against the pre-Lehman high is revealing. Interest payments went up by 170\% over this time period, while the operating profit grew by 32\% and the top line grew by 60\%. This has given a deterioration of credit risk measures of many firms.

These conditions add up to low growth in net profit. The index of net profit is at values seen in 2005. A sharp decline has taken place from 2010 onwards, which reversed the gains from 2005 to 2010. In other words, over the last decade, the Indian corporate sector has not expanded net profit measured in nominal rupees.

Buoyancy of net profit growth is the ultimate foundation of stock prices. The market awards a high P/E ratio when it believes that the E will gow a lot in the future. For a decade now, the market has been optimistic, but the earnings growth has not come about.

There are strong signs of a two speed economy. All the numerical values described above are macroeconomics: they are the sum of all non-oil non-finance firms. They subsume a class of firms, roughly a third of the corporate balance sheet, which is faring quite badly. The remainder of the firms is faring quite well.

How does this evidence shape our thinking about macroeconomic conditions and macroeconomic policy? There is a marked contrast between this picture and that reported by the CSO. The CSO believes that GDP growth in real terms in Oct-Dec 2015 was over 7%, but the net sales growth of listed firms in nominal terms was -0.42%. To reconcile the two views might require CPI deflation of over 6.5%.

We should worry that the official estimates of GDP growth are overstated. This has difficult implications for the stance of fiscal policy. So far, the debate surrounding fiscal policy has consisted of external experts criticising the proposal of the government to go off the Chidambaram/Kelkar fiscal consolidation trajectory that helped stave off an imminent credit rating downgrade. If, however, the official GDP growth rates are overstated, this means that deficit/GDP or interest/GDP or debt/GDP ratios are all understated. Even staying on the trajectory may mean fiscal metrics which are worse than meets the eye.

The macroeconomic environment of the good years was predicated on high GDP growth. High GDP growth was why India got an investment grade credit rating despite having fiscal problems reminiscent of sub-investment grade countries. High GDP growth gave expectations of high earnings growth, which underpinned high stock prices and the high leverage of firms. All these interlocking elements are now under stress. We may face a phase transition into a very different environment: the malaise of 1999-2002.

There is a way out of this dark tunnel, which is to undertake reforms. India is trapped in the political economy of incumbents who block change. The Bar Council blocks improvements to the legal profession; the tax bureaucracy blocks improvements to tax policy and tax administration; RBI blocks financial sector reforms; the education bureaucracy blocks education reforms; the health bureaucracy blocks health reforms, and so on. In each area, ground-up reforms need to be planned in meticulous detail, and teams established who can implement the work over long periods of time. When India will overrule the objections of incumbents, construct detailed blueprints for reforms and nurture teams who can push the change, the optimism of the private sector will change.

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