In today’s Finshots, we explain the latest results of India’s Flash Purchasing Managers’ Index.

The Story

How do you judge if an economy is growing?

Most of us would point to the Gross Domestic Product (GDP) to gauge growth. After all, it takes all the human activity in a country and compresses it into one figure. Whether someone’s manufacturing glass bottles or whether a hotel is providing rooms to tourists, it is all accounted for.

But the issue with GDP is that it takes time to tally up all these complex bits and pieces of an economy. And we get the results every quarter. It tells us what has already happened in the recent past. So it may not be great at telling us what’s happening right now or how things could shape up in the near future. We might already be in the throes of a slowing economy, or a big recovery, but the GDP takes its own sweet time to confirm it. That’s why economists call GDP a lagging indicator.

So ideally, we need something else that can give us a more immediate snapshot of the economy. We need a metric that signals how the future growth is shaping up. We need a leading indicator. And that’s where the Purchasing Managers’ Index (PMI) comes in.

Now calculating the PMI is straightforward. You just need to send a questionnaire to the senior executives of various business enterprises. You ask them to spill the beans on stuff they’re witnessing at the ground level. You pose queries about new orders, inventories, employment, costs, selling prices, exports, etc. And the respondents simply need to specify how these variables have changed compared to the previous month.

Sure, you could argue that it’s a survey, but it still is extremely factual. It’s not based on sentiment.

The only subjective question is asking companies to predict what their output would be in a year. So that’s an opinion given by the company executives.

Anyway, you can do this for manufacturing companies. And you can tweak the questions a bit and folks in the services sector too. So if the economy is more oriented towards services, it gives a clear picture of what’s happening month over month.

And a combined measure of both called the Composite PMI ends up doing a pretty good job of being a leading indicator of growth or a slowdown. Central bankers might even rely on these to decide whether to hike or cut interest rates.

If you look at India’s latest Flash India Composite PMI Output Index compiled by S&P and HSBC, the numbers are astounding. The PMI is at 61.3. And apparently, it’s the fastest expansion in factory orders and production in nearly 3.5 years!

But wait…how do you read the PMI, you ask?

Okay, the one thing you must know about the PMI is that it’s a diffusion index. This means that it simply counts the number of indicators with a positive change or a negative change.

For instance, let’s assume that we’re measuring 10 indicators. If 5 indicators report an improvement over the previous period and the other 5 falls, we say there’s a balance. And the diffusion index is at 50. But, if 7 indicators improve, then the reading is greater than 50. The exact extent of the reading depends on how the indicators are combined. And if the majority of indicators decline, then the diffusion index is below 50 and tells us the economy is contracting.

So you can see why a reading of 61.3 is cause for great cheer.

And since it’s a leading indicator, it’s sort of telling us that we can expect our GDP numbers to continue to look really good too. So it’s no wonder that in the past week or so, global agencies such as S&P and Fitch have all upgraded India’s growth projections too.

But wait…there’s one more thing we should mention. 61.3 isn’t the final PMI number for March. It’s something called the ‘Flash’ PMI. Think of this as an interim PMI or an estimate. It’s typically based on around 90% of the total PMI responses for the month and it’s published a week before the final PMI data for the month.

It’s fairly accurate to assume the final figures will be along the same lines too.

But sometimes, relying on the Flash PMI might lead to questionable outcomes too.

Let me tell you a story about such an instance in the UK.

See, in September, the country’s central bank was on the verge of deciding its interest rate policy. Everyone expected them to increase interest rates by 0.25% because inflation was playing spoilsport. And theoretically, a higher interest rate would dissuade people and companies from borrowing and spending money. In short, it would quell demand and lower prices.

But, on the eve of the big decision, the central bank received special access to the Flash PMI data. It was at an abysmal 46.8!

The figure flummoxed the policy-setters.

They believed that this PMI was a sure-shot indicator of an economic slowdown. And they thought it would be foolhardy to increase interest rates in such a situation. They were convinced that the slowdown would eventually lead to a drop in inflation too.

So they kept interest rates on hold.

But then, the final PMI number was published a week after this event. And lo and behold, it was close to 49. Things weren’t so dire. The economy was almost in balance.

Yet, inflation was high.

And analysts, who expected them to increase interest rates, jumped into question whether the central bankers had made a decision based on misleading data.

That’s not a good look for a central bank, is it?

Anyway, we’re not saying that India has something to worry about regarding the Flash PMI. But it’s something to keep in mind. It’s a lesson for the future that maybe we should wait for the Final PMI before any such big decisions are made.

PS: There’s one thing you must know about the PMI. It doesn’t indicate the magnitude of the movement. Or put another way, it doesn’t tell us the amount by which the indicators have changed. For example, you might have 3 indicators reporting a huge improvement, but 7 indicators that show a minor decline. In that case, the diffusion index will be less than 50. And we’ll assume the economy is contracting.

But hey, it’s not something we have to worry about right now since the economy seems to be going all guns blazing.

Until then...

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