Wednesday, 3 June 2015

The New GDP | Method, Critical Analysis

What is GDP?

GDP, Gross Domestic Product is the total value of goods and services produced within the country during a year. You take all final finished goods and services produced domestically in volume terms and multiply this by their market prices to arrive at the value of output. Intermediate goods need to be excluded to avoid double-counting.

For example, Let's suppose India makes:

  • 100 cars @ Rs. 25 each and 
  • 400 car seats @ Rs. 5 each
  • 50 software @ Rs. 100 each
So, GDP = (Volume of goods * Price of goods) + (Volume of services * Price of services

GDP = 100*25 + 50*100 (please note that the price of 400 car seats has not been included in this as car seats are intermediate. The price of car seats is already included in the price of the car. It can not and should not be counted twice)

GDP = 2500 + 5000
GDP = Rs. 7,500

Types of GDP:

  1. At Constant Prices: When the prices of a fixed year (called base year) will be taken for calculations, whatever may the current prices be.
  2. At Current Prices: As the name suggests, whatever price is prevalent currently, is taken for calculation.

Another thing you need to understand, GDP can also be:
  1. At Factor cost: Considering the prices of only INPUTS (or in other words the factors of productions) in production (like, salaries, raw material purchase, machine cost, etc.)
  2. At Market prices (basic prices): It's basically the MRP we pay, which includes various taxes that go to the Government (e.g. Excise tax, Sales tax, etc.). It helps in calculating Gross Value Added (GVA).
Nominal and Real GDP:
  1. Nominal GDP : total value of goods and services produced in a country in a given year. Affected by:
    1. increase in prices (inflation), or 
    2. increase in output
  2. Real GDP : total output of an economy in a year at constant prices, pegged to a base year.
    1. increase will only signify an increase in total output of the economy, as prices are kept constant - adjusted for inflation.
  • Market prices = Factor cost + Taxes - Subsidies
  • Gross Value Added (GVA at basic prices) = GVA (@Factor cost)  + Production Taxes - Production Subsidies
  • GDP (@Market Prices) = GVA (@Basic prices) + Product taxes - Product subsidies
  • GDP (@Constant Prices) [OFFICIAL GDP] = GDP (@Market Prices) adjusted to Inflation

For more clarity refer to this excerpt from The Hindu: 
"For a producer, GDP at factor cost represents what he gets from the industrial activity. This can be broken down into various components — wages, profits, rents and capital — also commonly known factors of production. Aside from these costs, producers may also incur other expenses such as property tax, stamp duties and registration fees, among others. Similarly, producers may also receive subsidies (production related) such as input subsidies to farmers and to small industries (not food or petrol subsidies that you get on the final product). It is important to note that only taxes and subsidies on intermediate inputs are adjusted. For arriving at the new gross value added (GVA) at basic prices, production taxes, such as property tax, are added and subsidies are subtracted from GDP at factor cost. Put simply, GVA at basic price represents what accrues to the producer, before the product is sold."

While considering growth of an economy (using GDP numbers), it could be taken at factor cost or market prices. As taxes are subject to changes (increasing market prices not factor cost), without any corresponding change in production, Growth WAS ALWAYS TAKEN AT FACTOR COST. The difference between the two is computed as TAX BURDEN of an economy (useful for international comparisons).

So what has CHANGED now?

  1. Base year - a routine exercise, done every 5 years
    • from 2004-05 to 2011-12
  2. New method to measure output is "Gross Value Added (GVA)"
    1. Shift from cost of final goods and services to Gross Value Added at each level.
  3. GDP calculated at MARKET PRICES, not FACTOR COST
    • So now what Government earns by way of indirect taxes (sales tax, etc.) after deducting subsidy is also added into the GDP
  4. Inclusion of financial services like Insurance, Broking etcetra 
  5. Larger universe
    1. Now the annual accounts of companies filed with the Ministry of Corporate Affairs (MCA21) is used, which includes ~5 lakh factories, including ones from informal sector.
      1. Earlier, data from Annual Survey of Industries - with record of ~2 lakh factories 
  6. Online data being filed with the Ministry of Corporate Affairs, instead of manual, as was the practice earlier

Advantages: Why did we adopt the new method?

  • More in line with global practices
    • For example, IMF’s world economic outlook projections, which all of us used even recently to make India-China comparisons, are not based on factor costs. This used to create confusion
  • As the base year has changed, it has helped in ensuring that the goods and services included in the GDP calculation reflect the present state of the Indian economy. 
    • E.g. - Recycling industry, trading activities by manufacturing firms are now included leading to increase in share of Manufacturing sector in GDP.

Negatives: Why is the new method in controversy?

  • Revision led to sharp increase in India's growth numbers. They do not match with other leading indicators of industrial activity, such as the Index of Industrial Production (IIP), which still shows weakness in data released in June 2015.
    • Government explanation for the same is:
      • IIP is a pure physical ‘volume’-based measure of production. It does not adequately reflect the ‘value’ that is added by virtue of quality improvements, higher production efficiencies, or marketing and branding innovations. Thus, a company that has made the transition from generic to branded products may produce the same volume of goods as before, but would now be adding more value. 
      • Benefits accruing to manufacturers on account of the sharp decline in commodity input prices over the last year and more. A refinery will add more value without producing a single extra litre of petrol and diesel, if its cost of crude has fallen much more that the price of its products.
  • Economists are baffled at how such a sharp growth could go unnoticed when, at the ground level, companies are still grappling with weak demand, high debt and low earnings.
    • Real test is evidence on the ground, based on actual company results.
      • An analysis of 286 manufacturing companies that are part of the BSE-500 index list and have announced their results, shows their net sales to have registered a 2.3 % decline in 2014-15 over the preceding fiscal.
  • Inconsistencies in data collection while calculating GDP numbers.
  • No comparison with GDP before 2011-12. 
Conclusion: Company results are worse than ever. Mere growth in number is not enough.
In this background, let's have a look at the recent macroeconomic numbers:

(Sources: The Hindu Business Line, The Hindu, Business Standard, Economic Times)


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