Is India's GDP really higher than China's GDP?

Much has been said and written about India's latest GDP figure release: a 7.5% year on year growth rate for the last quarter of 2014-2015. This shocked economists and the markets alike, since the markets had priced in and expected a figure closer to 5.5%. When details of the GDP figure were released, it was shown that the spike was largely due to a new calculation methodology the government has adopted to calculate GDP growth figures.

Economists, however, don't quite seem to know what to make out of the new methodology. What's most surprising about the GDP figure release is how much skepticism and doubt shrouds over the calculation method. In essence, the new methodology is supposed to be more in line with "international norms".

Here is what we do know:

1. The base year used in the calculation has been changed from 2004-2005 to 2011-2012.
2. The data used to calculate GDP is now being taken from 500,000 companies instead of 2500 companies.
3. The markets clearly have no idea how to interpret the new reading. In fact, it would not be a stretch of an imagination to assume that the markets are not factoring in the new GDP figure at all.

And how do we know that third point? Because the day after the GDP figure was released (it was released at 5:30pm IST on 9th Feb, which is after market hours), the Sensex opened a 100 points lower than the close of the 9th. When a GDP figure is released at 2% above market expectations, something along the lines of a 1000 point jump up is usually what happens.

If the markets had faith in the GDP reading, the markets would have rocketed up on the 10th. And that's the beauty of the stock markets: what you see is what you get. And when one digs really deep into the calculation methodology, more questions come up than answers. In essence, it becomes very difficult to take the GDP figure at face value. Economists surveyed around the world all seemed to agree on one point: nobody really knows what to make out of the number.

More clarity on the calculation method is required. Here, we try our best to break down the calculation methodology and dissect exactly what the government did do. And, as the famous saying goes, "It's all in the details.”

Understanding the basics

Most of us know that GDP- that is, the Gross Domestic Product- is a value of the sum of all goods and services produced within a given year.

GDP can be calculated using two basic ways. The first is to use a method that takes economic activity, or "factor costs", into account; and the other method takes expenditures, at market prices, into account. In the latest GDP reading, India changed the methodology from the factor cost method into the expenditure (market price) method.

Furthermore, for each of these two types of readings, you can calculate a "nominal GDP" and a "real GDP". And this is precisely where the subtle change in the base year in the calculation can make a huge difference.

What is the significance of changing the base year from 2004-2005 to 2011-2012?

A cursory Google search shows that the GDP figure rose largely due to the fact that the base year changed. But how does changing the base year cause a change in the GDP figure?

There are two ways GDP can be calculated. There is a nominal GDP, which does not take inflation into account. Therefore, let's take a hypothetical example where the total value of goods and services during a given year did not change at all from the previous year, but prices rose by 4% on average (inflation). Using nominal GDP, the GDP growth rate would be 0%.

Therefore, it makes sense to not use nominal GDP but to instead use Real GDP, which is how India's GDP is calculated (and has always been calculated). In order for a Real GDP to be calculated, however, there needs to be a base year off of which the GDP growth rate is calculated. The inflation in prices between the base year and the current year is taken into account to calculate the Real GDP.

So this brings us to the obvious question: how does changing the base year from 2004-2005 to 2011-2012 change the value of Real GDP?

Through deduction, the answer seems obvious. If we use 2004-2005 as the base year, the rise in prices (inflation) is higher than if we use 2011-2012 as the base year. Another way to look at it is that if we use inflation adjusted prices based on 2004-2005 as the base year, today's "market prices" will be lower than if we use 2011-2012 as the base year. This small "tweak" is not abnormal; every 5 years or so, the base year is changed to account for a proper usage of inflation to calculate Real GDP. However, it does have an impact; and seeing how inflation has been falling over the past two years, inflation adjusted prices using 2011-2012 as the base year will cause the prices used in the calculation of GDP to be higher.

What is the significance of changing the GDP calculation based on a "factor" based approach to an "expenditure" based approach?

This brings us to the second way that the GDP calculation changed: going from a method of calculating GDP growth based on economic activity (factor costs) to calculating GDP growth based on expenditures.

The main difference has to do with value-added-services, especially within the manufacturing sector. Using the existing factor based approach, the government's involvement was not included. However, by using the expenditures approach, we are able to add all domestic expenditures made on final goods and services in a single year. This includes consumption expenditures, investment expeditures, government expenditures, and net exports. The major difference between the two approaches, in this case, is that government expenditures played a large role in bumping up the GDP growth figure.

As we know, the "Make in India" model involves the government spending a significant amount in government reforms and, consequently, expenditures. The Make in India model is also heavily focused on the manufacturing sector. Therefore, it comes to no surprise that using the expenditures approach, manufacturing makes up 17.3% of the GDP, as compared to just 12.9% based on economist expectations using the factor based approach.

Take the following into account:

1. India is taking a focused effort towards evolving into an exports based economy (not just through IT and Pharma, but also through traditional "import" heavy based sectors like manufacturing and defense), and that one of the components of GDP is net exports. Therefore, an expenditures based approach more accurately prices the value addition of the goods and services being exported.
2. The government's expenditure is being priced in; therefore, all reforms that the government is undertaking to propel sectors is being priced at an expenditure level,  which was not the case earlier.
3. The expenditure provided through value-added services from the private sector is being priced in at a higher level than before. For example, if a large enterprise company is not only producing goods but is also providing value added services through marketing efforts to market its goods, the factor based approach would not have included the marketing spend. Through the new expenditures model, the marketing value is being priced in.

And so it becomes quite clear how the  expenditures based approach pushes the GDP value up.

So does this mean that the Indian economy is actually growing at a faster pace than China?

The answer, unfortunately, is that it's too early to tell. Despite having all this information, the mere fact that so many changes were incorporated into this new calculation method will take time to digest. There are still many unresolved questions: should the GDP figure have an impact on the RBI’s stance on interest rates? What does this say about the UPA’s government, seeing how in retrospect India’s GDP did quite well from 2012-2014 by using the new calculation method?

And perhaps the most important question of all: if economists are having such a difficult time understanding the calculation methodology and its implications- how much of an impact will future GDP releases have on the markets?

Only time will tell.