equitymaster.

com
The economic growth of 7.4% needs to be taken with a pinch of salt
equitymaster.com
Wed, 2 Dec 2015

India is the fastest growing country in the category of large developing

economies. But the problems with calculating economic growth in India are not
so simple
The ministry of statistics and programme implementation published the
gross domestic product (GDP) data for India for the period July and September
2015, a couple of days back. The GDP, a measure of the size of the economy,
grew by 7.4% during the period in comparison to the same period in 2014.

If we just look at this number then we have to conclude that the Indian economy
is doing fabulously well. But other economic data clearly suggests otherwise.

The exports have been going down for the last 11 months.

The corporate earnings for the three months ending September 2015 saw a
growth of less than 1%.

The real estate sector is down in the dumps.

The loan growth of banks has been in single digits for some time now.

The bad loans of banks continue to grow.

Two wheeler and tractor sales, a reflection of rural demand, fell during the first
six months of the year.

The vehicle sales, a good reflection of urban demand, grew at a very low rate
during the first six months of the year.

The number of stalled industrial projects continue to grow.

The factories are running 30% below capacity.

And India has seen two deficient monsoons in a row.

So how is the economy still growing at 7.4%? The answer might very well lie in
the way the GDP growth is calculated. The 7.4% economic growth that we are
talking about here and which the economists, politicians and regulators also talk
about, is essentially the real GDP growth. The real GDP growth is obtained by
subtracting inflation from nominal GDP growth.

For example, if the nominal GDP growth is 11% and the inflation is 4%, then the
real GDP growth is 7%, to put it in a very simple way. This is essentially done to
ensure that the GDP numbers across different periods of time are comparable, by
removing the inflation component from the growth numbers.

The inflation number used in this case is referred to as the GDP deflator and it
deflates the nominal GDP growth to the real GDP growth. As the Chief Economic
Adviser Arvind Subramanian said in a recent interview to a television channel:
"They actually only measure the wholesale and consumer prices, the GDP
deflator is just constructed." The GDP deflator typically falls between the inflation
measured by the wholesale price index and inflation as measured by the
consumer price index. Also, given that it is a combination of both the consumer
price index and the wholesale price index, it is the most broad based measure of
inflation.

During the period July to September 2015, the nominal growth came in at 6%.
The GDP deflator on the other hand was at 1.4%. This was primarily because
inflation as measured by the wholesale price index number has been in negative
territory for a while now. For the months of July, August and September, it stood
at 4.05%, 4.95% and 4.54%, respectively.

The consumer price inflation on the other hand stood at 3.78%, 3.66% and
4.41%, respectively. Given that, the GDP deflator falls somewhere in between the
inflation as measured by the consumer price index and the inflation as measured
by the wholesale price index, it was at 1.4%.

Real GDP as explained earlier is obtained by subtraction the GDP deflator from
the nominal GDP. And this led to a real GDP growth of 7.4% (6% (1.4%).
Given that the GDP deflator was in negative territory, instead of deflating the
nominal GDP number, it has ended up inflating it. And this explains how an
economic growth rate of 7.4% has been arrived at.

The question that crops up here is why has inflation as measured by the
wholesale price index been in the negative territory? One reason for this has
been a fall in commodity prices, which has benefited the Indian economy. India is
a huge importer of commodities like oil. On the flip side, a fall in exports,
stagnant consumer and industrial demand, low private investment, etc., are also
reasons of falling inflation as measured by the wholesale price index.

Over and above this, the Reserve Bank of India governor, Raghuram Rajan
recently talked about the capacity utilisation of the factories being at 70%. This
has been falling from levels of over 75% in January to March 2013. This suggests
a significant slack in the economy. And it means that businesses really do not
have pricing power. This is reflected in the more or less flat corporate earnings.
All these reasons have led to a negative inflation number as measured by the
wholesale price index. This negative number has led to a negative GDP deflator
and that in turn has led to an inflated real GDP number.

In simple English many economic factors which are negative for the economy
have ultimately ended up becoming positive for the real GDP number. That's the
long and short of it and perhaps explains why the economy is "supposedly"
growing by 7.4%, even though all real economic indicators suggests otherwise.

Further, economists Pranjul Bhandari and Prithviraj Srinivas economists at HSBC

Securities and Capital Markets India, have raised some doubt regarding the
reliability of the GDP deflator. As they write in a research note: "Nominal
GDP...grew at a much slower clip than real GDP...implying that deflators have
fallen sharply into the negative territory. Parsing through details throws up more
questions than answers. We find that growth in services deflator, which is
infamous for high and sticky prices, was actually running below the industry
deflator. This is odd because manufacturing and industry at large should be the
prime beneficiaries of falling commodity prices and as such should run below
services (which is largely non-tradable) inflation."

What they mean here is that the inflation in services was higher than inflation in
manufacturing. This seems odd given that manufacturing should have benefited
more because of falling commodity prices.

Due to this anomaly the HSBC economists suggest that the "real growth is lower
than the headline reading suggests."

Capital Goods
With a total market size of US$ 92 billion and production valued at US$ 32 billion,
Capital Goods sector today, contributes to 12% of India's manufacturing output.

On the export front, India's share in global exports from the sector is currently
very low, ranging between 0.1% - 0.6% across various sub-sectors. In contrast, in
countries like China, Germany, Japan, Korea this range is between 7% - 16%
depending on the sub-sector.
According to data from World Bank value added manufacturing is 17% of Indias
GDP. See References for further details.
Capital goods can be divided into nine broad sub-sectors: Machine tools, Process
plant machinery, Heavy electrical machinery, Textile machinery, dies(dies,
moulds and tools); Earth Moving equipment, Metallurgical machinery, plastic
processing machinery and engineered goods.
India has been moving from a stage of exporting low value goods to developing
countries to a stage of exporting high value goods to developed countries. 60%
of Indias total engineering exports now go to US & Europe.
Indian engineering exports grew at CAGR of ~11% to US$ 56.7 bn in FY13 from
US$ 33.7 bn in FY08

Capital Goods sector reveals that its fortunes are inextricably linked with that of
the overall Indian industry. High degree of correlation between the performances
of the two sectors is further accentuated by high elasticity of Capital Goods
industry to changes in industry growth
Machine Tools: Mother sector of the industry 800 manufacturers largely SMEs;

Revival will be triggered by - i) Sustained recovery in consumption demand

leading to increased capacity utilization and ii) investment push by public sector
leading to a virtuous cycle of cash flow generation in the system
Revenues of global industrial players suggests that the sluggishness has
continued for ~8 quarters now Middle east. Sharp depreciation of EUR that has

improved the competitiveness of European players in the traditional markets of

SE Asia and Africa along with Rupee appreciation
Manufacturing IIP remains sluggish and is down 0.8% in 3QFY15 (3mma), while
capacity utilization (as monitored by RBI) has declined to 71% in 2QFY15 (from
peak levels of 79% in 2QFY10)

Drivers
Make in India: Development of industrial clusters, simplification of
documentation processes and regulatory requirement with focus on import
substitution as well as increased exports
Example: Auto-components are being sourced in India from Indian companies
like Amtek Auto, Motherson Sumi and Force Motors. The automobile majors like
Mercedes Benz and BMW assemble in India while sourcing some components
from these Indian auto-components manufacturers and save on import duty as
well as expensive auto parts. This reduces the cost of luxury automobiles and
makes them more competitive in the market.
Digital India is set to massively boost the electronics hardware sector. Some
prominent investments include
Reliance Industries will invest over Rs 2.5 lakh crore, including in rollout of its
wireless broadband infrastructure and manufacturing of mobile handsets
KM Birla would invest $9 billion over the next five years in network rollout and
infrastructure, and towards other digital projects
Bharti group was committed to investing Rs 1 lakh crore over the next five years
in building digital infrastructure
LCD panel fabrication unit by Sterlite for 40,000 crore
Other drivers
The Indian mandated that Central PSUs, Central government
ministries/departments must procure 20% of products and services from Micro &
Small Enterprises (MSEs) thus boosting the small enterprise manufacturing in
India.
Also, harmonization of tax structure in the form of GST will reduce bureaucracy
and inefficiencies.
The effect of 49% FDI in defence can be gauged in form of JVs between Indian
and foreign companies e.g. Mahindra Defence and Airbus Helicopters JV. This will
boost defence manufacturing in India as 40% of defence budget is spent on
capital acquisitions
100% FDI in medical devices
Investment in railway infrastructure is a key priority for the Railways Ministry.
This will benefit Indian companies like Texmaco, Titagarh Wagons and Fedders
Lloyd

Electrical machinery: During the last 8 years, exports have increased at a CAGR
of 14.8% to touch USD 4.9 Billion in 2013-14. The industry is wholly de-licensed
with 100% FDI. The government has a planned capacity addition of 88.5 GW
projected at the end of 2017 through the Accelerated Power Development
Reform Program.
Power Plant Equipment: As India grows in manufacturing prowess and
development, it needs to fulfil the growing power requirement in the country.
This will help power plant equipment manufacturers like L&T MHPS Boilers Pvt
Ltd, a JV between L&T and Mitsubishi Hitachi Power Systems which makes
boilers, turbines and generators for power projects
Weaknesses
Bridging the technological gap
Concrete implementation of policy initiatives in land acquisition as well as efforts
underway to i) unlock mining activity, ii) widen the space for foreign direct
investment in defence, insurance and railways, iii) expediting project approvals
and iv) supportive monetary conditions
Export performance has been hamstrung by a multitude of factors, including: i)
weak global demand, ii) geopolitical tensions and iii) sharp currency volatility in
several markets

Recommendation: Astra Microwave (Rank 1 in Business Todays Fastest-Growing

Emerging Companies segment with revenues of 500-1000 crore)

References
http://data.worldbank.org/indicator/NV.IND.MANF.ZS
Manufacturing refers to industries belonging to ISIC divisions 15-37. Value added
is the net output of a sector after adding up all outputs and subtracting
intermediate inputs. It is calculated without making deductions for depreciation
of fabricated assets or depletion and degradation of natural resources. The origin
of value added is determined by the International Standard Industrial
Classification (ISIC), revision 3. Note: For VAB countries, gross value added at
factor cost is used as the denominator.
http://www.business-standard.com/article/news-cm/national-capital-goods-policyon-the-anvil-public-consultation-underway-115051900381_1.html
http://www.dnaindia.com/money/report-suresh-prabhu-to-unveil-his-vision-forrailways-in-white-paper-2048251
http://www.business-standard.com/article/current-affairs/govt-s-digital-india-callgets-rs-4-5-lakh-cr-promise-115070200064_1.html
http://businesstoday.intoday.in/story/emerging-companies-2015-astramicrowave-b-malla-reddy-plans-ahead/1/221084.html
http://economictimes.indiatimes.com/news/defence/push-for-make-in-indiaairbus-mahindra-to-jointly-manufacture-militaryhelicopters/articleshow/47923573.cms
http://timesofindia.indiatimes.com/india/Hike-in-defence-FDI-cap-fails-to-lureinvestors/articleshow/46522466.cms
http://www.pharmabiz.com/NewsDetails.aspx?aid=85648&sid=1