Introduction
The
advance and revised estimates for the year 2016-17 gave as some indication of
the effects of demonetization on GDP growth. However, there were doubts and
disagreement between analysts about whether the negative effects would be
limited to Q4 of 2016-17. With the CSO releasing data on Q1 of 2017-18, we are
in a better position to provide a quantitative impact of demonetization on GDP,
as the effects of demonetization can be separated from the earlier deceleration
of growth from its quarterly peak in mid 2015-16. We are also in a position to
take stock of earlier forecasts of GDP for FY 2017-18.
Demonetization
From the GDP data now available, we estimate that
Demonetization reduced GDP growth by ~1.2% point in first half of 2017 or by
~0.6% point in 12 post-Demonetization. This is at the mid-point of my forecast
range of -0.2% to -1% on 12 month basis[i]. The methodology, though far from perfect,
accounts for /adjusts for the decelerating trend in quarterly GDP growth since
the middle of 2015-16.
Deceleration in GDP growth
GDP growth
decelerated from 7.9% in July-Sept 2015(Q22015-16) to 5.7% in April-June
2017(Q1 2017-18), while GVA decelerated from peak of 8.2% to 5.6% over the same
period. Our analysis suggests that the GDP growth deceleration
since mid-2015-16 is due to the following factors:
(a) Monetary policy has not only been tight for
last two years, but has tightened over last 18 months because of sharply
falling inflation. The real repo rate has been on an uptrend from the beginning
of 2014, rising from a neutral 0.3% in January 2014 to 6.3% in august 2017. The
direct negative effect of rising real interest rates has been strongest on
manufacturing and construction, Another consequence of high real rates relative
to global rates, is excessive capital inflows into debt (and carry trade, which
gives free money to foreigners). This results in appreciation of the real
effective exchange rate of the Rupee (REER 36), which has appreciated from
104.7 to ~120 over the same period. Since February 2015 it has however moved
progressively above the gradually appreciating trendline & appreciated by
6.6% till July 2017. This in turn resulted in loss of competitiveness &
worsening of net exports of goods (Exports-Imports: X-M), which are almost 62%
of its absolute value in Q2 2015-16 and 48% of its absolute value in Q1
2015-16.
(b) A return of the Indian economy from deflation
to inflation in manufacturing & other internationally tradable goods. Inflation
measured by the deflator for manufacturing, which was negative from Q1 of
2015-16 to Q1 2016-17 turned positive in Q2 of 2016-17 and has risen
progressively since then. Similarly inflation as measured by mining deflator
turned positive i Q3 2016-17 for the first time since Q2 of 2014-15. The
deflation results in leads and lags in input & output prices that result in
overestimation of value added in manufacturing & other goods, while the
return to normal inflation reverses these effects on inputs & outputs so
that average growth measures values which would have prevailed in absence of
deflation episode.
(c) Public Sector bank(PSB) NPAs were incurred
largely in 2009-13, after the Global Financial Crisis(GFC) in 2008, partly
because of the unjustified euphoria generated by quick recovery in 2009 due to
appropriate fiscal monetary policies. The recovery led to abandoning of fiscal
sobriety in 2010 & lending pressure by government on Public sector banks.
However, the increasing NPAs were more hidden or in speculative domain. Tighter
regulations on NPAs since 2014 and their disclosure to public forced Banks, companies and capital markets to see &
evaluate the risks more carefully and clearly, worsening Credit/Investment in
2015 & 2016.
Reforms for Growth
With uncertainties and risks from introduction of
GST still hanging over the economy, the key question at this point is what
specific policy changes can help revive growth: The following reforms, in order
of feasibility and impact, should be accelerated by government:
(1) Government
must refocus on subsidy reform and put the savings from reduction in corruption
and administrative efficiency, into public goods infrastructure investment.
This will be an important driver of grwoth as long as private corporate
investment remains weak.
(2) It
should expeditiously complete already launched reforms in Bankruptcy law, rules
& procedures and the cleanup of the NPAs in PSBs.
(3) To get the full benefits of GST and minimize
the costs, the GST council must undertake drastic simplification of the GST (to
3 slab System with one base rate, basic food, health, education as exempt
sectors & surcharges on 6-12 carefully selected indutries+services).[ii]
(4) Reform Export-Import (EXIM) policy (Agriculture,
Textile), and unify customs (import) duty into a uniform
10% duty on all manufactures & minerals (GST is seperate).(a) Suspend the IT-electronics
agreement for 3-5years (if possible). Either
through EPZs or FTZ or other temporary mechanisms (5-10years) provide an
opportunity to Labor intensive industries & Export Supply Chains to shift
base from China to India.[iii]
(5) Two consecutive normal monsoons provide an
opportunity to eliminate all export controls & QRs on agricultural commodities and reduce export
duties to zero immediately. If government wants to help farmers on a permanent
& longer term basis, it should also repeal ECA & APMC, approve all GM
seeds recommended by the GEAC & induce hold-out States to join the National
e-market for all agricultural products. Remaining impediments to FDI in food
retailing of agricultural & related products should also be removed.
(6) Education is one of the remaining heavily
controlled sectors of the Indian economy. Central Govt. can make a start by
replacing controls on higher education with modern, rational regulation (based
on asymmetric information & moral hazard problems faced by users).
(7) Reform of the two most distorted markets,
labor & land, are not 0-1 processes. They have multiple dimensions, each
one badly riddled with controls, distortions and corruption. So a phased
program of labor & land reform can be drawn up and implemented step by step
over next five years as political opportunity permits.
Outlook
In my judgment the negative effects of
demonetization on GDP are largely over. Because of fears of getting
shortchanged on input credit from GST, there was an inventory draw down in
June, and a possible slowdown in production even before that. Both these will
be offset in August and Q2 of 2017-18. On balance I expect the economy to
bottom out in July, but the speed of recovery will depend on the reforms &
Monetary policy. 2017-18 GDP Growth is likely to be below my mean forecast of
7.5%, but within the range of 6.75% to 8.25% that I had forecast at the
beginning of the financial year.[iv]
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A version of this article appeared in Economic Times on 8/9/2017 under the banner, " Post-demonetisation economy: Exorcising DeMo’s demons" at https://blogs.economictimes.indiatimes.com/et-commentary/post-demonetisation-economy-exorcising-demos-demons/
[i] http://dravirmani.blogspot.in/2016/11/demonetization-economics_16.html
[ii] https://www.facebook.com/arvindvirmani2/posts/780808875419702
[iii]
Further details in tax reform chapter of forthcomng book: India at 70 years,
Modi at 3 years
[iv] http://dravirmani.blogspot.in/2017/03/gdp-2016-17-and-2017-18-forecasts-cso.html
, http://dravirmani.blogspot.in/2017/02/monetary-policy-8217.html
(a) AV, "Towards a Competitive Economy: VAT and Customs Duty Reform," Planning Commission Working Paper No. 4/2002-PC, April 2002. http://www.planningcommission.nic.in/reports/wrkpapers/wp_vat.pdf ; Arvind Virmani, "Customs Tariff Reform," Economic and Political Weekly, Vol. XL No. 11, March 12-18, 2005, pp. 1006-1008
(a) AV, "Towards a Competitive Economy: VAT and Customs Duty Reform," Planning Commission Working Paper No. 4/2002-PC, April 2002. http://www.planningcommission.nic.in/reports/wrkpapers/wp_vat.pdf ; Arvind Virmani, "Customs Tariff Reform," Economic and Political Weekly, Vol. XL No. 11, March 12-18, 2005, pp. 1006-1008