PMI and GDP

PMI or Purchasing Managers’ Index and GDP of a country are known to move together. Let us examine what PMI actually tells us and if the hypothesis of PMI and GDP moving together holds true.

When we talk of the performance of the manufacturing sector of the country, Purchasing Managers’ Index or PMI is one of the most widely used indices. PMI is an economic indicator that surveys purchasing managers at businesses that make up a given sector. It is a composite index with five sub-indices, viz., production level, new orders, supplier deliveries, inventories and employment levels. On the questionnaire, the managers mark these indicators relative to the previous period. PMI is a very important sentiment reading measure not only for manufacturing, but also for the economy as a whole.

50 is the magic number- a reading of 50 or higher represents that the manufacturing sector is expanding. If the manufacturing sector is expanding, the general economy should also be doing likewise because when manufacturing sector grows, backward and forward linkages come into play. Agro based industries grow and allied services also develop. Thus, it is considered a good indicator of future GDP levels.

But there are certain qualifications that we should keep in mind here. PMI of 50 or higher may not necessarily mean that the economy is doing relatively well. As the name suggests, PMI measures only the performance of the manufacturing sector. If manufacturing is not the dominant sector of the economy, a consistent rise in PMI might not translate into GDP growth over the previous period. There is always a possibility of growth in manufacturing not leading to growth in non-manufacturing sectors. This happens when the backward and forward linkages are absent.

In the case of India, the contribution of services to the economy is more than that of manufacturing activity. Now had these services developed because of manufacturing, PMI would have been a good indicator of GDP growth rate. However, the services sector in India developed faster than the manufacturing sector. India moved from being an agrarian economy to a services driven economy, with manufacturing never getting the bigger share of the pie. Thus, this development had little backward linkages. For reading India’s PMI we need to consider this scenario. Only when service sector develops through manufacturing, can we conclusively say that PMI will translate into GDP growth over period and reflect true sentiment in the economy.

Let’s have a look at the data. Till July 2013, India’s PMI was above 50. Our GDP is growing albeit at a slower pace. Here is an example where a PMI of above 50 doesn’t reflect the true sentiment in the economy. For emerging economies of India a low growth rate over the previous period is looked down upon.

Such a mismatch can also arise when the economy is recovering from a slowdown. When the economy is rebounding from a recession, new orders come in, production has to be increased. Till the time production is increased- inventories go down- which was high during the recession. Out of the five components of PMI, four would go up. But one factor going down can have a depressing effect on the overall index. Thus, even though the GDP growth rate might be more than the previous period, it immediately might not translate into a higher PMI.

India’s PMI for the first time since 2009 has fallen below the benchmark level of 50. A PMI of 48.5 represents that manufacturing sector is not expanding. This data is for August 2013. However, with Index of Industrial Production recording an increase, the number for PMI too is expected to improve next month.

PMI is the timeliest data available (every month) to get an idea of the health of the economy. However, while interpreting the number, these qualifications must be taken into account.

Contributed by:

Prerna Banga

Section A, Economics

Batch 2013-15