The new year begins in a haze of uncertainty. The risky decision by the Narendra Modi government to withdraw banknotes of high value from circulation, or what has popularly come to be known as demonetisation, delivered a demand shock to the Indian economy just when various economic indicators were looking better, helped undoubtedly by a good harvest after two years of drought.

There is as yet little clarity about the extent of the impact on economic activity since the only evidence that is available right now is either anecdotal or focused on individual sectors. Traditional forecasting models based on past trends are of little use when the economy has been given a structural shock. Warring tribes of partisans have chosen to grab the evidence that suits their political positions, even as the most extreme forecasts of a total economic collapse do not seem to have been borne out, if one goes by the prices of goods that are not perishable.

What lies ahead? Here are a few issues that deserve attention.

First, it is quite likely that the effects of the currency policy will linger on even after the Reserve Bank of India (RBI) releases the entire stock of new notes into the economy. The monetary policy committee of the central bank said in its December meeting that the effects of demonetisation are likely to be transient. Arvind Panagariya, vice-chairman of government think tank NITI Aayog, has also said disrupted supply chains eventually get rebuilt. But this cannot happen overnight. It could well take two quarters for the Indian economy to regain its lost momentum.

Second, it will be worth seeing how the government responds to the transient slowdown, if it chooses to respond with a stimulus in the first place. Monetary policy is not a very effective tool in these circumstances, and the new flexible inflation-targeting framework anyway goads RBI to look beyond temporary shocks so that inflation expectations can be stabilized in the medium term. The six members of the committee did not sound too sanguine about inflation in their December comments about the state of the economy. That leaves the fiscal policy lever.

Third, finance minister Arun Jaitley will announce his new budget on the first day of February rather than the usual last day of the month. A panel headed by veteran bureaucrat N.K. Singh should by then submit its report on the contours of a new fiscal law to replace the old Fiscal Responsibility and Budget Management Act. The most immediate recommendation worth looking at is whether the new fiscal law will replace a single point fiscal deficit target with a range, just as the new monetary policy framework has given RBI an inflation range.

Fourth, a more flexible fiscal deficit target could create space for the government to spend more in a bid to counter the demand slowdown after demonetisation. So, higher public spending could be unleashed to soften the blow from lower private sector demand. What happens to public investment in roads is especially important, since this sector has strong multiplier links to other parts of the economy. The other possibility that is swirling in the air right now is a direct transfer of cash into Jan Dhan accounts, perhaps as a first step towards a universal basic income.

Fifth, the economic recovery will not be broad-based as long as the balance sheets of banks and large firms continue to be under stress. These two are mirror images of each other. The past two years have seen a bunch of policies meant to help banks to go after loan defaulters. Some over-extended conglomerates have also been selling assets to raise cash. There have been lots of individual deals, but they have not as yet added up to a significant reduction in balance sheet stress. Neither bank lending nor private sector investment can take off unless excess corporate leverage is dealt with.

Sixth, the global situation is also changing. The US under Donald Trump could shift to a new macroeconomic mix of tighter monetary policy and looser fiscal policy. This switch could have a profound impact on countries such as India. Higher US interest rates are usually the cue for capital outflows from India, especially the bond markets. More US spending on infrastructure could push up commodity prices, though the persistent slowdown in China will most likely act as a cushion. But crude oil prices have climbed in recent weeks. Every $10 increase in crude oil tends to push up inflation by 0.5 percentage points, the current account deficit by 0.5 percentage points and the fiscal deficit by 0.1 percentage point.

These are some concerns as the new year begins. The overall picture still looks good. Inflation is under control as of now. Economic growth should recover in the second half of the calendar year. The government should hopefully use the next 12 months to push the reform agenda; the window will close as it begins to prepare for the 2019 general election. India can continue celebrating the now tired fact that it will grow rapidly in a sluggish world. Yet, the harsh truth cannot be ignored. The next wave of strong growth will not gather pace till bank balance sheets are cleaned up and politically influential business groups are forced to cut their excess leverage.

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