What is the optimal policy response to demonetisation?

In recent weeks, the debate has inevitably turned to the optimal policy response to demonetisation, and whether the forthcoming budget should deliver a large consumption stimulus, even if it comes at the cost of a significant relaxation of the current fiscal consolidation path. This essay analyses the different criteria that should determine the policy response, to suggest that the economic case for a large consumption-driven fiscal response—if it comes at the cost of fiscal prudence—appears very tenuous.

When formulating a policy-response to a shock, the first question that must be asked—apart from the estimated size of the shock—is whether it is expected to be temporary (one-two quarters) or more enduring (six-eight quarters). The day after demonetisation, the economic concern was that a substantial fraction of the old tender (say, 30%) would not return to the banking system. This would have constituted a large, permanent negative wealth shock, which could have depressed consumption for some length of time. That fear has not materialized. Reports indicate that more than 95% of the old tender has been deposited. Instead, to the extent that some of the deposited “wealth” is taxed and spent as “income” in the budget, aggregate demand will actually rise as long as the marginal propensity to consume out of this deposited “wealth” was previously less than one. Consequently, not only will there not be a negative wealth shock, but aggregate demand could actually rise!

Any hit to growth, therefore, is likely to be temporary, stemming from the existing cash crunch. The sooner and more broadly the economy is remonetised, the more quickly this shock is likely to fade. Even conservative estimates suggest the economy will be sufficiently remonetised by mid-year.

Therefore, if the impact of demonetisation is expected to be a two-three quarter—albeit potentially sharp—growth shock with things normalizing by the first quarter of the next fiscal year, why do we need fiscal policy to be relaxed for all of 2017-18? By the time fiscal policy kicks in, in the second half of 2017, activity is likely to already be rebounding as discretionary consumption—postponed on account of the cash crunch—will likely be mean-reverting. Fiscal policy should undoubtedly be counter-cyclical. But one needs to distinguish a Lehman-like exogenous shock from a temporary liquidity crunch. Against this backdrop, any benefits of output stabilization from a fiscal relaxation—particularly given the timing mismatch—would appear to be more than offset by the negative impact on debt dynamics, especially when deteriorating state finance already poses a threat to debt dynamics.

This is not to suggest that there will be no medium-term impact on activity. But the real question is, will it be a lingering demand shock or a negative supply shock? If it’s the latter, is a fiscal stimulus really the answer?

One of the natural—and desirable—medium-term implications of demonetisation is that it will push parts of the informal economy into the formal economy. This is clearly a desirable objective. Initially, however, it could lead to some disruption, because several small and medium enterprises (SME) exist and compete largely because they are not formal and don’t incur the costs of participating in the formal economy. The government is exactly right that this activity needs to move to the formal economy. But when they do, some of these firms will essentially cease to become viable or competitive. The question is where does this resulting activity shift to? It could migrate to formal, larger manufacturing. Equally, however, it could initially be replaced by cheap Chinese imports, particularly since India’s bilateral real exchange rate has appreciated almost 10% against the Chinese yuan since the latter began to depreciate in August 2015. Chinese imports perhaps still remain the biggest threat to Indian manufacturing, with the bilateral trade deficit with China accounting for 40% of the total trade deficit. Whatever the replacement, this would be akin to the supply curve moving back (i.e. a negative supply shock) for some period of time.

Even if this were to play out, however, the optimal policy response is not a consumption boost from the budget. That will not make these firms any more competitive. Only supply-side reforms—infrastructure, labour laws, cost of capital—will cause them to become viable in the formal economy. To its credit, the government has been pushing on factor market reforms for the last two years. We need a continuation of that. A positive demand shock is not the optimal response to a negative supply shock. Instead, it will only exacerbate price pressures.

There could, of course, also be a more lingering impact on consumption/investment if certain asset classes (for example, real estate) remain depressed and there are knock-on effects from any job losses and bankruptcies in the informal/SME sector.

Some countercyclical policy response would be appropriate here. But guess what? A monetary stimulus is already under way. The gush of deposits into the banking system since demonetisation—and the expectation that some of these will be permanent—has resulted in a significant easing of monetary conditions. Government bonds have rallied sharply, driving a significant flattening of the yield curve, even as yield curves all over the world have steepened sharply since the US election. Lower government bond yields, in turn, mean lower corporate bond yields. Furthermore, bank lending rates have been slashed by about 80 basis points since demonetisation. All this has meant that monetary conditions have eased to a 30-month low.

Easing monetary conditions should drive some supply response. Lower cost of capital for firms in the informal economy will help them remain viable as they migrate to the formal economy. Lower market interest rates should also help real estate and consumer durables—discretionary sectors that are perhaps most affected by demonetisation.

What’s particularly desirable about the liquidity-driven easing of monetary conditions is that it is auto-correcting. The longer it takes to remonetize the economy, the more flush the banking sector will be with liquidity and the more benign will be monetary conditions. As the economy is increasingly remonetized—and growth concerns abate—the inter-bank liquidity surplus will reduce, and monetary conditions will gradually normalize, although they will continue to remain more accommodative than pre-demonetisation, given the permanent nature of some fraction of deposits.

Separately, contrary to popular perception, state finances have been deteriorating in recent years. The consolidated state deficit has increased from 2.2% of gross domestic product (GDP) in FY14 to 2.9% in FY15 and is pegged at 3.3% of GDP in FY16, despite much higher transfers from the Centre under the 14th Finance Commission. Furthermore, with growth expected to slow in FY17, state revenue particularly sensitive to stamp duties from the real-estate sector, and several states poised to implement their own pay commissions, state deficits are expected to widen further. The stress is already showing up in yields: The average state bond yield spread over Central government security has widened from 45 basis points in October to about 75 basis points in the most recent January auction.

All this is likely to imperil consolidated debt dynamics, and use up any fiscal space that may have existed. It also means that the consolidated fiscal deficit may end up being stimulative in FY17 despite the central deficit being reduced meaningfully.

Finally, should the budget prioritize consumption or investment? In the last two years, the problem has not been consumption, but investment. In the four quarters before demonetisation, private consumption grew at 7.7% whereas investment contracted by 2.3%. One could argue that a “consumption stimulus” would increase capacity utilization and spur private investment in manufacturing. But in a world floating with excess manufacturing capacity—particularly in China—one could equally argue that it would take a brave entrepreneur to invest in manufacturing. Instead, rising capacity utilization could equally spill over into higher manufacturing imports.

In contrast, the infrastructure sector—weighed down by stressed balance sheets and elevated non-performing assets—desperately needs more public investment to crowd in private investment.

Policymaking is not easy amid heightened uncertainty. But as the dust settles from demonetisation, here is what we know. First, any shock to growth is likely to be temporary and activity can be reasonably expected to recover before next year’s spending gets under way. Second, in the medium term, a supply shock is just as likely as a residual demand shock. Third, an auto-correcting monetary stimulus is already under way. Fourth, state finances are on course to deteriorating meaningfully, imperiling consolidated debt dynamics. All this would argue against a large consumption stimulus that abandons fiscal consolidation.

To be sure, a modest slowing of the pace of fiscal consolidation is likely already priced into bond yields. But to completely abandon fiscal consolidation next year—as some in the market are advocating—will dent credibility, trigger a tightening of financial conditions and, therefore, neither be efficacious nor optimal. The government deserves enormous credit for resisting this temptation last year. Now it must do an encore.

Sajjid Z. Chinoy is chief India economist at JP Morgan. These are his personal views.