ICRIER forecasts India’s GDP growth rate using ‘leading Indicators’. Leading economic indicators (LEI) are variables considered to have significant influence on the future level of economic activity in the country. They give advance signals about the likely growth rate and allow us to forecast GDP growth five quarters ahead of the value of leading indicators. The predictive quality of LEIs has earned them the name ‘leading’ indicators. They predicted growth of GDP at 9.2 per cent for 2007-08 in November 2007, while most agencies had predicted a lower growth rate of 8.5 per cent or below that year, as against the actual growth rate of 9 per cent. ICRIER was first to predict a growth rate (before the crisis erupted) of 7.8 percent for 2008-09 in July this year, an estimate that was thereafter adopted by others, including both the Reserve Bank of India (RBI)and the finance minister.
The leading indicators index relies on ten key indicators: 1) production of machinery and equipment, 2) sales of heavy commercial vehicles, 3) non-food credit, 4) railway freight traffic; 5) cement sales, 6) sales of the corporate sector, 7) fuel and metal prices, 8 ) real rate of interest, 9) BSE sensex and 10) GDP growth rates of the US and Europe.
A composite index for the leading economic indicators has been constructed for the period 1997-2008 with the quarterly series of growth of these variables (except for the real rate of interest where the level, and not the growth, has been used) using the ‘principal component index’ (PCI) method. The PCI method assigns weights to each leading indicator component by a process of iteration based on its contribution to total variation in the composite index.
Leading indicators can predict future growth based on what has already happened in the past but cannot capture the impact of sudden external shocks which may have an immediate impact on the economy. Examples of such shocks in the past have been the bursting of the IT boom in 2000-01 (Q3 2000-01 to Q2 2001-02), crop failure in 2002-03 (Q2 to Q4 2002-03) and the recent US financial meltdown (starting with Q3 2008-09 and say, up to Q2 2009-10). The leading economic indicator index (LEI) with a 5-quarter lag and the shock represented by a dummy variable (equal to 1 with shock and 0 without) are used to forecast India’s future GDP growth. The growth equation builds in the previous shocks of the dotcom bust and agricultural failure and its estimates track actual GDP performance very closely as shown in the chart below. For projecting the GDP growth for 2008-09 and the next year, the LEI index incorporates the expected shock from the current global financial meltdown.
The estimated equation for GDP growth forecast is satisfactory with adjusted R-square value of 0.58 and t-values for the regression coefficients of 3.24 for LEI (-5) and -5.95 for the shock variable, both significant at the 99 per cent level of confidence. The GDP forecast for 2008-09 and for the first half 2009-10 is tabulated below alternatively for both with the shock and without the shock.
GDP Forecast for 2008-09 and H1 2009-10
No shock With shock
2008-09 7.5 5.8
2009-10 H1 6.8 3.9
As the chart shows, India would have grown 7.5 per cent this year (a slowdown from 9 per cent in 2007-08), had the global crisis not occurred. The global crisis is likely to bring India’s growth rate to below 6 per cent in 2008-09. With the first half GDP growth rate already known, this implies a sharp slowdown in the next two quarters. In the first half of next year, the economy would have grown below 7 per cent in the absence of the external crisis. The global crisis may reduce Indian growth rate to less than 4 per cent in 2009-10 [It may, however, be noted that we have not calibrated the intensity of the different shocks and the impact on growth is treated similarly for all shocks. If the current shock is more serious than the previous ones the growth may fall even further].
The implications are significant. For starters, the Eleventh Five Year Plan targets should be recalibrated immediately if that exercise is to remain credible. We should prepare the people for slowdown in employment generation and plan for counter cyclical measures urgently. This implies the need for an immediate reduction in interest rates to bring down the cost of capital and a quick and thorough review of government procedures that vitiate the investment environment and hike up transactions costs.
Rather than throw more money at the problem, it is important that the government identify infrastructure projects, like the highway program, where some additional resources but a lot of attention to implementation and execution can generate additional capacities and help raise growth. But some counter-cyclical fiscal measures will surely have to be taken. Perhaps one that needs to be considered seriously is a cut in central excise duties as this will lower prices and bring forth new demand. That would also add weight to the Finance Minister’s demand for industrialists to reduce prices.
Policy makers now have to deploy all tools at their command to boost business sentiment and consumer confidence both of which are badly shaken. It is an extraordinary situation seeking extraordinary measures.
The authors are Director & Chief Executive, Senior Consultant and Consultant at ICRIER, New Delhi.