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The pace of rebound will depend on the repair work to fix the dislocations due to demonetisation and also on the reforms to address the longer-term structural issues. Photo: Ramesh Pathania/Mint
The pace of rebound will depend on the repair work to fix the dislocations due to demonetisation and also on the reforms to address the longer-term structural issues. Photo: Ramesh Pathania/Mint

Repair, reform and rebound

Demonetisation holds out the prospect of long-term gains, but the economy might need some succour now to boost sentiment

A proper analysis of India’s economic outlook in 2017 will have to look beyond the shadow of demonetisation, which looms large on the economy in the near term. The pick-up in consumption growth that we were hoping for in Q3 and Q4-FY17 is unlikely to materialize and there could be further delay in any recovery in private investment too.

We believe the growth normalization process will be a direct function of high-velocity availability of Rs500 notes. There were approximately 16 billion pieces of Rs500 notes before demonetisation. Our working assumption is that consumption activity will normalize when about 50% of the Rs500 notes are back in circulation. This would imply about 80% of the high-value notes being remonetised.

FY18 recovery is likely to be consumption-led. The pace of rebound will depend on the repair work to fix the dislocations due to demonetisation and also on the reforms to address the longer-term structural issues. We do not think that there is enough evidence as yet to suggest that the demonetisation exercise has damaged India’s structural growth story and expect GDP (gross domestic product) growth at 7.5% for FY18 on a low base of FY17. Wealth loss, income loss or job loss can have a permanent impact on purchasing power but it is too early to suggest that demonetisation has unleashed such a vicious cycle.

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On the other hand, multiple gains from demonetisation can be reaped if followed by complementary reforms. An expansion in tax revenue might happen through one-time penal taxes on earlier undisclosed income, but more interestingly the “shock and awe" effect of demonetisation could lead to better tax compliance. This process can be further accelerated if adoption of digital payments improves the audit trail and “formalization" of the economy widens the tax base.

Gains can also accrue from higher bank deposits and household financial savings. We anticipate that in the new equilibrium post demonetisation, bank deposits will go up by approximately Rs2.5-3 trillion above their trend growth. This takes into account two factors—some part of the earlier storage demand for currency will not be converted back into cash and the push to digital payments will ensure that money stays within the banking system. We expect credit growth to improve from its historical lows as lower lending rates encourage credit demand, but it is unlikely to go back to double digits any time soon. In fact, evaluating creditworthiness to avoid large-scale adverse selection would be a critical challenge for the banking system as it tries to deploy the windfall deposits in a low interest rate environment with not too many shovel-ready projects.

While we are hopeful about long-term gains from demonetisation, the economy might need some succour now to boost sentiment and it is more likely that the government will have to provide it. It will try to balance the priorities of boosting consumption, rewarding honest taxpayers, supporting redistribution and continuing with its capex thrust. In the process, the fiscal deficit to GDP ratio might be pegged at 3.4%, rather than the 3% originally envisaged in the Fiscal Responsibility and Budget Management road map. Higher oil price is likely to squeeze incremental revenue opportunities, but that is unlikely to deter the government from either a substantial increase in rural and social expenditure or a rationalization of personal income-tax slabs.

Reviving the private investment cycle is still a work in progress. Companies are deleveraging as interest rates fall and equity raising in the primary market gathers pace, but lack of demand is keeping animal spirits low. Continued stress in the financial system is another headwind. The progress on the implementation of the insolvency and bankruptcy code will be critical in determining the pace of the resolution of the non-performing assets issue in 2017.

Job creation is another structural aspect which deserves policy focus in 2017. In India, about 80% of the firms have less than 10 workers and about 90% of the labour force works in the informal economy where demonetisation is likely to have the maximum impact. There is no discernible sign of generalized increased unemployment post demonetisation, but heightened uncertainty might have delayed employment growth. We believe new job creation strategies have to be formulated to increase the share of manufacturing jobs, reduce informal jobs and meet the aspirations of educated youth.

ALSO READ: Time to revamp the tax administration

One of the key risks to watch out for in 2017 is going to be higher oil prices. In our view, a $1 per barrel increase in oil price worsens the current account deficit by $1.4 billion and raises government subsidy by Rs15 billion, though the CPI (consumer price index) impact is low. Until about $65 per barrel, the shock appears absorbable. But investors will have to guard against any risk of macro instability if oil prices continue their northward journey.

Sticky inflation—excluding vegetables, 94% of India’s CPI basket is witnessing a price rise of 4.8% year on year—and elevated household inflation expectations imply that the battle against inflation is not over. With the risk of global commodity prices inching up further in 2017, we expect average FY18 inflation to firm up towards 4.9%. While headline CPI might undershoot the March 2017 Reserve Bank of India (RBI) target of 5%, the adverse base effect in the September-December 2017 period could push up CPI towards the upper band of the RBI’s target range before returning towards 4.5% levels in March 2018.

Monetary policy support to rates is waning as the mantle is passed on to the fiscal. We expect only a 25 basis points rate cut in 2017, a rate cut is more likely in April than in February. Given our marginally higher inflation forecast and more balanced bond demand-supply dynamics, bond yields could back up towards 6.5-6.6% levels by year-end. The theme of gradual range-bound depreciation of the rupee could continue, but we are mindful of the risks towards further depreciation as global uncertainties persist.

Samiran Chakraborty is managing director and chief economist, Citi India.

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