Pity Indian policymakers who don't know which data to go by for economy

Five years on from demonetisation some strange things have happened to the economy. A lot of data is pointing in divergent directions. 

This makes things harder for policymakers because not only do they have to work with contradictory data, the date also doesn’t quite reflect reality. 

Consider, in this context, two reasonable proxies for economic activity—cash in circulation and digital transactions. 

According to RBI data, cash in circulation as of August 2021 was Rs 29.4 lakh crore, much higher than the Rs 17.8 lakh crore it was in the month preceding demonetisation.

Some part of this can be put down to the uncertainty the pandemic has brought. Indeed, economies around the world have seen similar increases in cash in circulation as people increasingly opt for a ready emergency fund. 

But the fact remains that cash in circulation in India was Rs 23.5 lakh crore in February 2020, a month before the nation-wide lockdown was announced and well before Covid-19 was a major threat in India.

As to digital transactions, data from the National Payments Corporation of India shows that digital financial transactions amounted to Rs 165.53 lakh crore in FY 2020-21. 

In the first seven months of this financial year, that number is already Rs 123 lakh crore. The number for the full year is thus likely to exceed the previous year’s total by quite a lot.

Even if you assume that the move towards digital transactions is pandemic-induced, the Rs 160.9 lakh crore digital financial transactions in FY 2019-20, which is nearly 18 percent higher than in the previous year, shows that there was a clear increase in such transactions, even pre-pandemic.

Add to these two data trends the recent analysis by SBI’s economics research wing, which points towards increasing formalisation of the economy. 

Let’s start by assuming that the size of the economy has remained the same over the last few years. If that be the case, it is reasonable to assume that an increase in digital transactions would mean a commensurate reduction in cash transactions, with the converse also holding true.

If both digital transactions and cash are higher than they were, the assumption of the economy being the same size cannot hold. It should imply that the economy is larger than before.

However, as we all know, GDP data has not only shown that economic growth is slowing, but also that the absolute size of the economy right now is smaller than it was two years ago. (Or is it?)

We also know that the GDP number largely only measures the formal economy and only very vaguely estimates the size of the informal economy.

In short, the four trends mentioned above--higher cash in circulation, higher digital transactions, increasingly formalisation, and smaller absolute size of the economy--should not be able to coexist. 

If cash and digital transactions are increasing, the size of the economy should not be smaller. If the size of the economy as measured in the GDP figure is indeed smaller, then higher cash transactions would imply that increasing formalisation is not happening. 

Something’s got to give.

What this likely means is that economic activity is higher than what the GDP number is being able to capture, and that the informal sector is doing far better than the formal. 

The problem policy makers face is that this increased economic activity is largely invisible to it, and so cannot be factored in. 

Designing policies meant for a smaller economy that is actually larger is sure to have unintended side effects. The rising inflation we are seeing is likely one such, but there are sure to be others.