Business World,  July 10, 2011

The first quarter economic growth, though lower than last year’s, has been touted as investment-heavy and possibly a harbinger of better things to come.  According to the newly-revised National Income Accounts (NIA) series, investments surged 37% year-on-year in the first quarter, a pace of growth that has not been achieved in more than two decades based on the old NIA series.  [In the first quarter of 1990 investments grew by 39%.]

If true, this is of vital importance because the failure of the country to achieve sustained and inclusive growth is frequently blamed on the country’s historically low investment level, especially by the standards of our East Asian neighbors.

But is it true or is it an artifact of recent changes in national income accounting?   A closer inspection of the revised NIA series, which came out only in May, reveals that investment grew by an even higher 38% in the second quarter of last year – and has averaged almost 33% growth since the first quarter of 2010.  This did not make the news and attract attention because in the old NIA series, which was all we had at that point, investment was reported to have grown by only 10.8% in the second quarter of last year, a significant growth but not newsworthy given the inherent volatility of investment.

NIA Revision

The huge gap in investment growth under the two series in recent quarters is explained by the methodological revisions adopted in the new series in the rebasing to 2000 (from 1985).  The revisions were undertaken by NSCB to better conform to international standards and to make use of updated and even new data, including the input-output table for 2000.  On investment, some of the more important changes were the inclusion in this category of intellectual property products, research and development, computer software and databases, mineral exploration, original artistic works, and military expenditure – all reasonable changes.   As a result of the rebasing and reclassifications, the investment ratio is now estimated at 20.5 percent in 2010 from 15.6 percent in the old series.  [The correlation between the old and the new investment ratios from 1988 is a mere 0.22, and between investment growth is 0.07.]

But another change that has had a profound impact on investment growth estimates is the shift to the use of a Supply Use Table (SUT) to force the statistical discrepancy in the NIA to zero.  The statistical discrepancy, which is the difference between the estimated output from the production and expenditure sides, was a cause of concern because in some years it exceeded 5 percent of GDP.  The production side GDP is the binding estimate and the statistical discrepancy used to be a separate item under the expenditure side NIA.  The SUT is an attempt to match supplies coming from different industries and imports to intermediate and final uses.

However, in practice it appears its main effect is to re-classify what used to be the statistical discrepancy as additions to (or deductions from) change in inventories.  As the discrepancy disappeared, the share of inventory accumulation rose substantially – from less than one percent to 6 percent in the fourth quarter of 2010 when comparing the old versus the new series.  It has also become a lot more volatile.

If one breaks down investment growth in the first quarter by component, what we see is that 62.4 percent of the improvement in investment is simply due to an increase in inventories.  Only 28.1 percent was due to durable equipment build up, 7.9 percent to construction, and less than one percent to accumulation in intellectual property rights.

Stated another way, minus the change in inventories, investment growth in the first quarter would only have been 12 percent – decent but not extraordinary.   It likely would not have made the news as it would even be much lower than the average quarterly investment growth last year under the old series.  In fact, minus the change in inventories, expenditure-side GDP growth would only have been 0.6 percent instead of 4.9 percent.  [Minus the change in inventories, the correlation between the new and the old investment series is 0.88, and between growth is 0.77.]

So is it true that producers are massively accumulating inventories?  The new series also shows an even higher inventory accumulation in the fourth quarter of 2010.  Is it a sign that producers are highly optimistic about the future pace of consumption?  Or did they grossly miscalculate and overproduce, perhaps on the mistaken assumption that the previous year’s growth will be sustained this year?

Here we run the danger of over-analyzing.  There are perfectly good reasons as to why there should be a discrepancy between the production-side and the expenditure-side estimates of GDP.  The NSCB itself cites them: the use of different data sources and methodologies; sampling and undercoverage of some industries; parameters that have not been updated; and other technical reasons.  Furthermore, the large contribution of remittances to domestic demand likely introduces added difficulty in matching the production and expenditure sides, because it is difficult if not impossible to separate consumption financed by remittances from those financed by domestic income.

It behooves NEDA and the NSCB to clarify the proper interpretation of the new investment series, especially the inventories component.  Perhaps the temporary solution is simply to report investments with and without the change in inventories component, until it has been properly clarified.  Some accidental good may come from the unintentional over-reporting of investment growth – it may boost optimism and generate further investments.  But there is also the danger that we may be lulled into thinking that we are doing everything right when it may not be the case.