Understanding the GDP slowdown in India in the quarter of Demonetization
- In Economics
- 10:07 AM, Jun 14, 2017
- Ananth Natarajan
The GDP growth rate in the last fiscal year ending in March has dipped to 7.1% from the 8% for the previous financial year as per provisional estimates from the Central Statistics Office whose National Accounts Division is responsible for the preparation of India’s national accounts including GDP. This 1% dip in the growth rate is almost certainly due to the effect of the “demonetisation” exercise undertaken by the NDA government.
Let us discuss this briefly after putting it in context.
It has been well established that sustained growth over a long period is that is essential to lifting the average income of the country and is the key to increasing standard of living, thanks to the pioneering work of Nobel Laureate Prof. Simon Kuznets who developed measures of national income. MIT economists such as Nobel Laureates’ Prof. Robert Solow and Prof. Samuelson did further pioneering work on explaining the causes of growth. The current high standards of living in the US and Europe were achieved by decades of moderate growth rather than growth that reflects the boom and bust cycles in Latin America. For instance, the average US GDP growth rate was about 2% per year for the entire list century resulting in about an 8 fold increase in GDP per capita over the period. Incidentally Prof. Kuznets was Dr. Subramanian Swamy’s doctoral advisor at Harvard University.
Therefore measures that promote sustained growth are critical over measures that incentivize short term spurts.
The key to growth in India lies in under the Consumption at about 60% and Investment at about 30% heads in the Aggregate Demand valuation of the GDP account. Furthermore sustained Investment is necessary for the supply side to be able to meet Consumption growth in the demand side. It is unlikely that exports will play a major role in India’s future GDP growth, it historically has not, and furthermore current global conditions are not very conducive.
Demonetisation is one of several steps by the NDA government to curb “black money, and expand the size of the formal economy and tax base. It was announced past the end of the Income Disclosure Amnesty scheme in 2016.
A brief survey of the rationale, costs and possible benefits based on a few key facts is presented here.
The benefits of demonetization will appear over the long term while the costs will be more apparent in the short term. The expected benefits are both several and significant and include the reduction in the size of the unaccounted economy, increased tax base, increase in accounted money, increase in bank deposits, increase in lending and lower interest rates due to increased bank deposits, controlled inflation, setback to state sponsored counterfeiting, check to terror financing and several more. The actual benefits accruing to each of these will accumulate over the long term and the net benefits can best be understood by over the years to come. Exploring this offers material for a stream of academic papers for many years to come. But several indicators to these positive effects are already discernable. There are 9.1 million new taxpayers in 2016-17, an 80% increase over the typical yearly rise. Verification of millions of unexplained deposits is still underway. Bank deposits rose by more than 10%; the State Bank of India (SBI)alone saw its deposit base increase by over 18% from 2016 to over Rs 20 lakh crore by March 2017. The excess liquidity can be expected to lead to lower interest rates that can help in recovery from the NPA situation and help with the GST transition.
Some benefits were seen in November 2016 itself, 47 urban local bodies to the Union urban development ministry show their tax collection increased by 268% in November 2016 compared to the same period last year. As an example Mumbai municipality’s tax collection was Rs. 11,913 crore that month, compared to Rs. 3,185 crore it collected last November.
Electronic Money helps to increase consumption by increasing money velocity as the spending of cash is not constrained by its physical movement across from hand to hand. Increased deposits of money in banks instead of having it locked up under the mattress or in inflated real estate puts the money to work by funding Investment. The unaccounted “Black economy” was once estimated by the World Bank to be about 23% of the GDP.
Investment in physical infrastructure in largely driven by the government in India and this activity is a key constituent of the GDP. India had a very low Tax to GDP ratio of about 16.7% in 2016, compared to 25.4% in the US and 30.3% in Japan. Therefore increased tax collection is an important benefit.
A slowdown was expected to occur post demonetization by everybody concerned given the removal of a principal transaction medium in the economy and the resulting short-term liquidity squeeze. The ratio of currency to GDP in India was about 12%, high by global standards. This was due to the hit to consumption as well as the lost productivity from time spent in dealing with the consequences such as by queuing up to exchange bills. Compare this to the dire predictions of doom from several quarters: The previous Prime Minister, Dr. Man Mohan Singh, had incredibly predicted to the parliament that the GDP would shrink by 2% in December 2016! Not a reduction in growth by 2%, but a reduction of the entire GDP by 2%. And he went on to add that: “this is an underestimate and not an overestimate”.
Ironically growth reducing to 7% from 8% for a single quarter during demonetization is very good, especially under the circumstances. India is still the fastest growing major economy in the world. It is good to review the reports and opinion of key Multilateral Institutions and International Ratings Firms for a dispassionate and objective view of the impact of demonetisation on growth.
The opinion amongst them can be summed up in this quote from a report by Moody's Investor Service "The negative impact of last year's demonetisation on the economy has been limited in size and duration". They further predict that the economy will grow 7.5 per cent in fiscal year 2017 and 7.7 per cent in fiscal year 2018 and will accelerate to 8 per cent. The IMF in May 2017 said that the GDP growth rate will be 7.2% this fiscal and 7.7 per cent in 2018-19. The World Banks’s opinion communicated via its bi-annual economic India Development Update that same month is similar.
The government has done well by controlling inflation from about 12% in 2014 to less than 4% today, and moving the GDP to a new stable normal of 7% growth in just a few years. They have been working hard on Government spending through speedy and efficient project clearance and implementation, and on increasing FDI to where India has one of the highest inflows in the world. FDI has seen a huge jump from $34.5 billion to $61.7 billion since 2013. The increase in road construction to more than 20km per day, the National Waterway projects with associated multi-modal terminals, and the increase in port capacities from 745 metric tonnes per annum (MTPA) in 2013 to 1,065 MTPA in 2017 are all good examples. These projects help with the current GDP by generating present work and also help future growth by improving infrastructure.
The increase in FDI flow will be further helped by the recent liberalization of foreign direct investment rules in several key sectors such as Railways, Defense, Railways, Civil Aviation, Insurance etc.
Reaching a new normal of 10% in the medium term will require all engines of growth to be revived. This will be dependent on key reforms such as the GST rollout, resolution of Non-Performing Assets (NPA) and the ongoing infrastructural improvements. The GST roll-out can be expected to cause another short-term marginal blip in the rate of growth, but is essential for sustainable long term growth. Further structural reforms such as Land Acquisition and Labor Reforms require accumulation of further political capital that will hopefully accrue from the 2019 General Elections.
The resolution of the NPA situation to revive private investment is a difficult challenge requiring innovative thinking due to the political sensitivities involved with debt ridden corporate houses. Ironically the NPA situation was created when exuberant borrowing by Indian companies went into projects that were delayed and stalled by the UPA government, nominally headed by Dr. Man Mohan Singh, to where they turned into NPAs. This was happening at a challenging time of crashing commodity prices and a challenging global environment. It is not difficult to understand what happens when a corporate house borrows heavily to build a power plant that does not take off because of stuck clearances and policy deadlock, and has to keep paying the interest on the loans. At some point, interest servicing becomes difficult with existing income flow and the loan becomes an NPA in the Bank’s portfolio. The price to pay for the decade of policy dead lock, lack of structural improvement, and lack of initiative by the UPA government was high, and continues to have an effect. It is quite remarkable that Dr. Man Mohan Singh recently decided to blame the current Government for private investment not being a key driver in GDP growth. The present NDA Government and the RBI have done well by enacting several measures to force this issue into the open to where it can be dealt with. The Insolvency and Bankruptcy Law, passed in 2016, makes it easier to liquidate a failing business and recover debts. Financial crisis happens when underlying problems are hidden or not acknowledged until they blow up. Once again some immediate short term pain is essential to prevent a deeper longer term crisis.
To summarize, policies that create the basis for sustained growth even at the cost of a marginal dip in growth in the short term are essential. It is a fact that governments in India while planning for long term growth also have to contend with facing elections at shorter term intervals. This is a difficult balancing act. A government that risks its electoral chances by undertaking high risk reforms for sustainable growth definitely deserves support.
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