Sher Mehta, macroeconomist and econometrician, who heads the Macroeconomic Intelligence Unit of Macroeconomics School, London, in an email interview with Animesh Singh, discusses the effects of demonetisation on the economy and cautions that the economy may slowdown significantly in the third and fourth quarters of the current financial year.
Post-demonetisation do you foresee any kind of recession in the making in the country?
After growth picked up in the second quarter of the current fiscal (7.3 per cent according to official data), I expect the Indian economy to slowdown significantly in the third and fourth quarters — with much slower business momentum — though I don’t really expect a recession. As a possible reflection of the adverse impact of demonetisation, private sector business activity contracted in November as reflected by the composite PMI reading (which fell into contractionary territory for the first time since June 2015), with the dominant services sector (which accounts for above 60 per cent of GDP) contracting and manufacturing sector continuing to expand, but with lower momentum. In fiscal year 2016-17, I expect the Indian economy to now grow below seven per cent.
Demonetisation is a massive liquidity shock to the economy (86 per cent of currency in circulation was withdrawn). There are estimates that it will have a negative impact between 0.5 per cent to 3 per cent of GDP.
Further, it is estimated that it could take nearly six months to reinject sufficient cash into the economy, i.e. remonetise the economy. Until the liquidity shortage is alleviated significantly, consumption demand will continue to witness a slump (particularly in the rural areas) and the dominant services sector of the economy will be hit the hardest.
I expect the economic slowdown to continue till the first half of fiscal 2017-18. However, pent-up demand, remonetisation and the forthcoming Union Budget should all gradually impact the economy positively. As a result, I expect a gradual bounce back in economic activity from the second half of fiscal 2017-18 onwards.
What kind of economic growth do you see in the next fiscal in the aftermath of demonetisation?
I forsee a gradual pick-up in demand and economic activity from the second half of fiscal 2017-2018 due to reasons already stated above, along with possible recovery in corporate earnings. I expect up-tick in urban consumer demand, possible rate cuts (25-50 basis points) by the RBI and significant reduction in interest rates — over the next six months — given the huge inflow of deposits in the banking sector post-demonetisation that should help restart several stalled projects, revive capital expenditure with a lag, enhance demand for personal, consumer and housing loans (interest rates on which might fall by 100-150 basis points, which in turn should incentivise people to buy houses, before prices move up), all providing impetus to economic activity in the second half of 2017-18.
Further, given the high levels of non-performing assets (NPAs) plaguing the banking sector (particularly the public sector banks) and their impaired capital position, they cannot support significantly higher credit growth and are likely to remain risk averse, particularly on corporate credit segment, in the near future as they focus on cleaning up their balance sheets. Moreover, the rural sector in particular is likely to languish or witness suppressed demand for a few more quarters. All these factors will restrain growth in fiscal 2017-18. Overall, I expect a modest acceleration in growth in fiscal 2017-18 — anywhere between 7-7.3 per cent.
In what kind of economic scenario is a decision like demonetisation required? Do you think the timing was right for it in India?
In an economic scenario when cash as percentage of GDP is excessively high (in India’s case, it is estimated at around 12 per cent), there are substantial distortions in real estate and gold prices, significant speculative activity in real estate and equity markets takes place, persistence of high inflation is witnessed, very high interest rates that stymie industrial growth exist, there is considerable paucity of capital for development and growth purposes, and corruption and tax evasion is pervasive, demonetisation would probably be required.
The objective behind demonetisation seems laudable to me. With reference to the timing, well it would have been preferable if the demonetisation move was taken after the GST was implemented.
Will post-demonetisation scenario have any impact on the country’s tax structure?
Post-demonetisation the impact on the country’s tax structure would be felt over the long-term; personal income-tax rates could be lowered significantly across the spectrum and exemption limits could be hiked notably, as there is likely to be substantial rise in tax revenues, increase in tax to GDP ratio, widening of tax base, better compliance, improved tax collection and higher economic growth. Further, it could help in reducing corporate taxes — which would positively impact investment — and lower indirect taxes too.
Will the tax base increase due to shortage of cash?
Demonetisation will substantially increase the tax base and tax revenue in the long run as the share of the formal economy rises (currently the informal economy employs more than 80 per cent of the workforce and accounts for over 40 per cent of total output), rather than in the immediate aftermath of demonetisation where there is a substantial shortage of cash and economic activity is highly subdued.
What are the major sector which will be positively or negatively affected by demonetisation?
The major sectors likely to be negatively affected by demonetisation are the service sector, real estate and allied sectors, construction, consumer durables, automobiles (to an extent), FMCG sectors, gems and jewellery business and the rural sector.
What kind of Budget you think will be presented, considering the prevailing economic scenario?
It would possibly be a Budget that would focus on countering the substantial demand downturn in the economy as a result of demonetisation and prolonged stagnation in investment (i.e. continued decline in gross fixed capital formation) because of domestic and external demand slump, lower capacity utilisation, banking sector debts and deleveraging in the corporate sector.
Consequently, government infrastructure spending is likely to get a boost (though fiscal deficit concerns, implementation of Seventh Pay Commission and bank recapitalisation endeavours will be limiting factors), tax exemption limit may be enhanced from 2.5 lakhs to 3.5 lakhs, corporate tax may see a significant reduction (in 2015-16 Budget, the government had announced corporate tax to be reduced to 25 per cent in four years), tax slabs may be revised, personal income taxes may be reduced, social sector spending may rise substantially to alleviate distress of the poor in the post-demonetisation period, more sops for the beleaguered real estate sector and strong incentives are likely to given to incentivise digital transactions.
How has been the international reaction by economists on the demonetisation?
It has been rather diverse with some applauding the government for this courageous move in its resolve to fight the menace of corruption, while others have been critical about it due to the hardships faced by people, particularly in the informal sector that is cash-driven, prospects of substantial job losses and downturn in growth and whether such a move would be able to effectively curb black money in the economy.
Has there been any global impact of this decision? If yes, is it going to be a long term one?
Not really and I don’t envisage any such impact in the future or in the long term. Structurally, the India story remains intact and the government seems committed to reforms. Consequently, unless the demonetisation story for some reason affects India’s growth prospects beyond the short-term, I don’t expect any global impact in the long term.
