Macro Q&A August 2018

Q1: RBI came out with a report saying that 99.3 per cent of the banned currency has come back. This has led to a debate where on one hand opposition is saying that demonetization hurt the economy by decreasing GDP and on the other hand government is claiming that it  led to formalization of economy and more tax collection. After nearly two years, how do you see the demonetization exercise? Does the benefit of demonetization outweighs its negative affects?

A1: As I had said from day one, the economic costs of demonetization would be higher than the economic benefits. The data that has come out so far confirms that analytical prediction. I am not in position to evaluate the intangible benefits and costs of Demonetization.

Q2: Opposition leaders had predicted a GDP growth reduction of 2-3%, what do you think?

A2: I had forecast a GDP growth reduction of about 0.5% for the full year, with an absolute upper limit of 1% of GDP. I have formally estimated the loss in a working paper as 1.2% points in the two quarters following demonetization, ie a total loss of 0.6% of ful year GDP. This is very close to my original estimate.

Q3: Were there any benefits of demonetization?

A3: in my initial analysis I had identified three potential benefits of de-monetization. One the immobilization of black money held as cash. Two, the increased income tax compliance and reduction in tax evasion & bureaucratic corruption. Three the reduction in black money in real estate. I had written that we would have to wait for data to quantitatively evaluate each of these.

There are straws in the wind about increased formalization of transactions & financialization of savings but there’s insufficient data/ evidence to link them to demonetization.

Q4: What is your evaluation, given the data published in the RBI annual report and the data put out by the CBDT/Dept of Revenue?

A4: The RBI report shows that 0.7% of demonetized notes did not return to the RBI. This compares with a number of 1.8% during the demonetization of 1978. If this is taken as a measure of the immobilization of the black money held in cash, the performance was 60% less than last time. In my judgement this is due to the increase in corruption in the Public Sector Banks over 40 years and its demonstration effect on Private sector banks. In the absence of reliable data on corruption, it provides an estimate of the deterioration in public sector banks ie corruption was 60% higher in 2016 than it was 40 yrs earlier.

Part of cash was, however, deposited in 1,48,000 accounts, with an average deposit of Rs. 3.3 cr. Some of this will prove to be tax evasion subject to taxes & penalties. We don’t yet know how much!

Q5: What about the gains in Personal Income tax compliance?

A5: CBDT data shows that both the number of income tax declarations and income declared for tax have increased. Income tax buoyancy with respect to nominal GDP has increased from 1 in FY15 & FY16 to 2.45 in FY17. This is higher than the 1.5 seen earlier in FY14. GST was introduced in July 2017 and there was consequently a lot of uncertainty. This likely had a negative or negligible effect on income tax declaration in H1 of FY18. Its still unclear how demonetization and GST interacted jointly on income tax decelerations in H2 of FY18.

Q6: Has there been any effect on black money in the Real Estate sector.

A6: There was an expectation that one of the collateral benefits of demonetization would be the reduction of black money in real estate. The only data we have to indicate such reduction is the ~30% reduction in prices in Mumbai & Delhi markets post-demon. There were also some indication that the traditional black-white ratio in transactions has gone down. It’s not clear however how long lasting this effect was. There has however been a general effect on speeding up the digitization of the economy.

Q7: Indian Rupee has fallen to a new low after crisis in Turkey's Lira. What is the reason for weakening of Rupee when Indian economic is much stronger than Turkey? 

A7: The most important driver of depreciation of EME currencies has been the appreciation of the US dollar against the index. There is also some apprehension about the effect of planned US interest rate rises on Emerging market economies dependent on capital inflows to finance deficits. Given our high dependence on oil imports, the impending imposition of Iran sanctions, its effect on trade deficit is also of some concern. As these are one-off factors, Rupee is likely to stabilize after some adjustment.

Q8: What is reason for FPI capital outflow? Is Indian market not as attractive?

A8: Historically short term movements in Exchange rate of rupee are linked to fluctuations in capital inflows. Besides the global factors mentioned above, fluctuations are also driven by expectations of political developments and politically driven Fiscal excess. It’s therefore very important for Govt to maintain it’s responsible fiscal stance during this period before the elections.

Q9: Fall in Rupee is expected to increase exports and imports. So what do you think overall what will be net impact on economy of fall in Rupee?

A9: The Sharp appreciation of the Real effective exchange rate (REER) of the rupee during 2017 was one of the factors, along with GST refund problem, for the slowing of export growth. The depreciation of the REER during 2018 has corrected much of the problem. It will therefor be a positive factor for export and help contain the current account deficit.

Q10: Moody's has said that due to increase in oil prices there is risk that India might not meet its fiscal deficit target for current fiscal? How do you see?

A10: Besides the global factors mentioned above, capital inflow fluctuations are also driven by expectations of political developments and politically driven Fiscal excess. It’s therefore very important for Govt to maintain it’s responsible fiscal stance during this period before the elections.

Q11: Current account deficit is also expected to widen this fiscal. Should it worry policy makers?

A11: Any rise of the Current Account Deficit above 2.5% of GDP always requires careful monitoring. However, to the extent it’s driven by oil price rises, it is usually followed by increased demand for imports from oil exporting countries & higher remittances from our citizens employed there. This is a lagged effect which should help moderate the rise.

Q12: Do you expect government curtailing its expenditure due to GST revenue being less than expectation, increase in oil subsidy (LPG and kerosene) and MSP. What will be its impact?

A12: With the decontrol of petrol and diesel prices, the direct effect of oil price rise on Govt deficit is limited. The rise in Kerosene subsidies is manageable. There will also be some offsetting increase in revenues, given the effect on oil prices on inflation. Govt expenditures are manageable as long as no major new schemes are introduced.

Q13: Do you see rise in inflation due to high fuel prices and MSP and as a result RBI hiking interest rates?

A13: Inflation has in fact moderated due to easing of food prices, though higher MSP may keep these prices from falling further. Average CPI inflation is likely to be between 4.5% & 5% during 2018-19. Good Monetary Policy is designed to moderate inflation, not to raise it, so I would be surprised if RBI raises real rates precipitously.

Q14: Is there any risk of government taking populist measure before 2019 Lok sabha elections?

A14: There is always such a risk before elections. But this Govt has already laid out its programs, among which the health insurance program is the most ambitious. I am hopeful that it will be phased in carefully without raising the fiscal deficit sharply before the election. There is also some concern about the potential rise if fiscal deficit of States!

   

Q15: What impact do you see of the ongoing trade threats being made by US on India? 

A15: The sanctions associated with CAATSA and Iran sanctions are part of the external risk factors for India. The effects of the latter are already in the market & were discussed above. Uncertainty about the former will hopefully be resolved in the 2+2 dialogue.

Q16: How do you see the Indian economy in 2018-19

A16: The Indian economy is now firmly back on its medium term growth path. This expectation is based on the recovery of fixed investment during last four quarters, the restoration of private consumption to its trend, and the renewed hope on export front. GDP growth in 2018-19 is likely to be 7.5% +/- 0.25%.

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References:

Arvind Virmani, "Growth Prospect: Deceleration, Demonitization & GST " http://dravirmani.blogspot.com/2017/09/growth-prospects-deceleration.html

Arvind Virmani, "Deceleration, De-Monetization and GST: Growth Prospects and Policy Solutions," Working Paper No 2/2017, September 2017.  GrowthDeceleration2017sep.docx  .    

Arvind Virmani, "Investment: Corporate India and Indian Households," Working Paper No. 1/2018, June 2018.

InvestmentFables2017.doc

Data Appendix: Income Tax Collections

Year    NomGdpGr   IncTaxGr

2011      20 %             14 %

2012      16 %             18 %

2013      14 %             19 %

2014      13 %             20 %

2015      11 %             10 %

2016      10 %             11 %

2017      11 %             27 %

Data curtesy Nilesh Shah:

Note: A version of this interview by Praveen Bali, appeared in the with Asian Age((http://www.asianage.com/opinion/interview-of-the-week/020918/data-confirms-economic-cost-of-demo-was-higher-than-benefits.html ) , Deccan Herald.

Q&A on Economy & Trade

 Interview given to Bijoy Kumar Sing of PTI on August, 9, 2018:

Q1: What is you assessment of current macroeconomic situation in India? Some experts believe that  the macro situation is becoming more challenging in the last year of Modi  government? FDI growth hits 5-year low in 2017-18, rupee has depreciated, oil prices and inflation are rising? 

A1: Economic growth, which has been subject to many ups and downs over the past seven years, seems to be back on a recovery path. The most important indicator of this is the rate of growth of real fixed investment, an essential element of sustained, sustainable growth. On the external front some challenges such as the threat of rising interest rates and commodity prices are the negative face of a rise in developed country growth. So they are partly offsetting. The rise in oil prices due to Geopolitical factors, like Iran sanctions are however a concern.  The US-China Tariff war however provides an opportunity to increase India’s exports to the USA and to attract, labor intensive elements of the global supply chain unsettled by higher “China risk”, to India. Domestically the main risk to macro stability, is politically driven Govt consumption spending at the cost of investment and fiscal prudence. If this temptation is resisted, the country will be back on a firm 7.5% plus growth track. 

    Q2: India has emerged as the sixth largest economy replacing France? How do you see this development?

A2: in a series of papers since 2004, I had predicted the rise of China and India as economic powers (https://sites.google.com/site/drarvindvirmani/india-great-power ). India will become the fifth largest economy in 2018 and the 3rd largest, after USA &  China, by 2025 (in current US dollars). According to the index I developed for making these projections, VIPP, India will become a great power by ~ 2035. It is very important for our elites to understand both the strengths and the limitations of these developments. We must start planning our global interactions and acting like a leading power, without ignorantly imagining that we are already a Great Power (that is 20yrs away). 

    Q3: The US actions on trade have emerged as the biggest worry for global growth. What will be impact of rising trade tensions on Indian economy and what should be India's strategy?

A3: We must distinguish between US trade actions against market economies like EU, Canada, Mexico and other market economies from those against non-market China. The conventional wisdom that everyone will loose from a trade war applies to the former, but not to the latter. A single party dictatorship has dozens of ways of imposing non-tariff barriers on imports & foreign investment, that free open democracies, run by rule of law, cannot even imagine. The US-China tariff war will have some short term disruptive effects on global economy, but provides great opportunity for India to attract Labour intensive, export oriented and Indian market oriented investment from those currently located in China. The Indian Govt, private industry and PSUs must make an effort to attract them to India.

    Q4: The general elections are less than a year away and there is a possibility of populist policies being announced by both the central and state governments. Is there a possibility of slippages in the fiscal deficit?

A4: Historically every Govt pushes up what are referred to as populist expenditure in the year or so leading up to the election. The test is if they keep it modest and don’t disturb the trend in fiscal responsibility. There is therefore always a risk of fiscal slippage. At State level, this is partly linked to losses incurred by State electricity distribution. 

    Q5: Prime Minister Narendra Modi had said that demonetisation will reduce generation of black money in India. But money deposited by Indian's in Swiss banks rose by 50 per cent last year. So, how do you read the effects of demonetisation nearly two years later.

A5: The data that I have seen shows that money deposited by Indians in Swiss banks has been on and remains on a downtrend. As as demonetization, I had written the week after demonetization that it would reduce the growth rate of the economy by about 0.5-0.6% in the 6 months following the demonetization or about 1% for the year as whole (assuming the recovery takes a year). My subsequent estimates show a loss of 1.2% of GDP in the 12 months following demonetization. On the positive side I had predicted an increase in income tax compliance, which seems to be happening (as per limited data available). The effect on black money in real estate and elsewhere did take place, but seems to have been less permanent. 

    Q6: There is common perception that departures of foreign' economic advisers (Raghuram Rajan, Arvind Panagariya and Arvind Subramanian) underline the Modi administration's rejection of free trade and open market approaches to policy in favor of protecting domestic industries and farmers. Your comments.

A6: Since I retired from the post of Chief Economic Advisor at the end of 2009, my successors as CEA (Kaushik Basu, RaghuRam Rajan and Arvind Subramanian) have all returned to jobs abroad, after completing their Indian tenure. The same happened in the case of Arvind Panagriya of NIti. In my judgement this is not primarily due to any disagreement on free trade and open markets, which is indeed one of the weak points of the current Govt (I have argued for trade reform in the, Bibek Debroy edited, book, “India at 70, Modi @3.5 “ )

    Q7: Recently Commerce Minister Suresh Prabhu had said that 40 per cent of India's GDP will come from exports by 2025, and India's economy will be a USD 5 trillion economy 2025. At present, exports constitute only 18 per cent of USD 2.6 trillion GDP. Do you agree with Prabhu?

A7: An open economy is one of the drivers of growth in a connected and liberal world, which is why I have continuously argued for reform and liberalization of EXIM policy(agriculture) and of import tariffs and export duties. I continue to do so. However, given the anti- free trade sentiments sweeping the world, we have to be a little more selective and cautious in dealing with non-market, non democratic countries which find it easy to follow non-transparent policies that harm our interests. This poses a challenge for instance in concluding the RECEP agreement.

Dolam To Wuhan: India-China Reset

Introduction

     The so called “Reset” in India China relations, has been widely and wrongly reported as a change in Indian strategy towards China. A few analysts also suggest that it is a change in Chinese Strategy towards India. If we define strategy and tactics conventionally, the arguments for either of these hypotheses is unconvincing. [i] To the extent it is a reset, it’s a tactical one extending the next few years, not a strategic one relevant for the next 5-10 years.

  India’s Foreign Policy has changed over the last five years along with its redefinition of itself as an “aspiring leading power”.[ii] There is an effort, since 2014, to define India’s interests more clearly and to pursue them without looking over our shoulder at every step, or to worry how third parties will respond to these policies. This applies to policies such as, (a) A firmer line, diplomatically and militarily, on Terrorism and (b) Building strategic defence capabilities through partnerships, including with USA. There is also an attempt to develop a more symmetric & reciprocal foreign policy with respect to China. This has not been abandoned, but tactics and operational actions must respond to new developments & this includes the reactions of the adversaries and partners. These include the Trade Defence (/war) launched by the Trump Govt against Xi Govt of China and the new risks it has created for FDI investors in China’s export industry, and the reverberations of the Doklam crises.

Symmetry & Reciprocity

         To understand the Xi-Modi informal summit of April 2018, and its implications, one has to step back to 2017 and two sets of events: On 17 April 2017 Dalai Lama visited Tawang and addressed thousands of Bhutanese devotees.[iii]  Chinese called this visit a provocation.[iv] India’s official formal Position on the Dalai Lama has always been clear: Following the millineal traditions of India and the 3/4 century traditions of democratic India, He is an honored Religious figure and is free to carry out his religious activities anywhere in India. It has been obvious for Long that the Communist China doesn’t see it that way, as to them Religious activity (e.g. in Arunachal Pradesh or Tawang) is indistinguishable from political activity. Going further the party and its media organs have arrogated to themselves the right to criticize visits of Indian dignitaries to Arunachal Pradesh.

   The second event followed within two months, likely the time it took the PLA to get approvals and orders from the top leadership & translate them on the ground. On June 16, 2017 Chinese troops with construction vehicles and road-building equipment began extending an existing road which ran roughly North North-East in the disputed Bhutanese Trijunction area of Dolam held by them, south South eastward across a little creek. On 18 June 2017, around 270 Indian troops, with weapons and two bulldozers, entered Dolam to stop the Chinese troops from constructing the road.[v]  The formal Indian position is also clear, that there is a written agreement, under which none of the parties will do anything to change the status quo in the India-Bhutan-China Tri-junction area now commonly referred to as Dolam area.[vi] India also has a long standing mutual security agreement with Bhutan under which it assists Bhutan in protecting its territorial integrity and security. India viewed the extension of the road SSE within the (Bhutanese) territory held by China, as likely to change the “status quo” in the Tri-junction area in favour of China and took action to stop it. The PLA and its leadership were shocked and dismayed by this Indian action, and apparently sought to convey to China’s top leadership as outright aggression by India on China, w/o bringing to its attention the Tri-junction agreement.

    It took two months to resolve the crisis diplomatically.[vii] Throughout this period the organs of the Communist Party of China, such as The Global Times, verbally attacked and abused India, a playing out of what I have termed the Three Wars Strategy ie Legal war, Media War and Psychological War (or PsyOps) . India, it’s government and even the media, in contrast, kept their diplomatic cool and played the issue without rancor or emotion.

   However, there was a period when it looked like the PLA may turn it into a hot war, on the species assumption that it still had, as in 1962, the ability to “teach India a lesson”. Indian forces were very confident that they could ensure China would not gain, in net terms, from a hot war; Further it was in a position of creating enough risk for the PLA that attacking Indian forces in the Northern boundary areas had a positive, even though small, risk of PLA ending up with egg on its face. India’s political leadership was equally clear that it was far more beneficial to all to resolve the issue through diplomacy instead of war.

Indian Motivation: Risk Reduction

   In Late February 2018, the foreign secretary requested the cabinet secretary to advise Govt officials not to attend events organized by the Tibetan leadership in exile. Though this was consistent with the distinction that the Govt of India has always made between Religious activities and political activities of the Tibetan exiles based in India, it was rightly seen as a signal to the Chinese leadership that India was ready to diffuse further the confrontational environment that had developed in 2017.

   From India’s perspective there were two important problems seen during the crises that needed to be corrected. One, was the impression, appearing repeatedly, that the top leadership was not fully and objectively briefed by the PLA and /or others on the Indian position on the Tri-junction boundary areas, whence the need for a top level informal summit. The second problem that seemed to emerge, was that the PLA and consequently the Chinese military commission headed by General secretary Xi, seemed incompletely aware of the capabilities of the Indian armed forces, particularly the Indian Air Force, circa 2018. This problem was sought to be addressed among other things by the Gagan Shakti exercise that preceded the “informal summit”.

  The uncertainty created by US sanctions on Russian defense companies and to a lesser extent on Iran, may have also weighed on Indian decision makers.

Chinese Motivation

    There seem to be two possible motivations for China to consider toning down the possibility of conflict, at this time. One is the largely negative reaction to Chinese efforts to expand its territory and territorial control across its entire periphery, stretching from the Himalayan border, through the South China Sea to the East China Sea, with a dawning realization that this is provoking all the effected countries to explore and expand security co-operation among themselves and with the USA & other powers in the Indo-Pacific.  Its reaction to the “Quad” is symptomatic of this concern, not necessarily a fear of the Quad per-se. The second more immediate and clear motivation is the “technology defence” and “trade war” launched by the US administration. By my estimate any direct trade war between USA and China could result in a 2%-point decline in China’s growth at the cost of a maximum 0.5% growth decline for the USA, a 4:1 advantage for the USA viz China.[viii]

    Even if the trade issue is resolved by China, by substituting imports from USA for imports from Rest of the World (ROW) to satisfy the obsession with the bilateral CAD with China, the uncertainty created for export oriented FDI in China will have a permanent negative effect on China. Such investment now has much greater incentive to diversify out of China to India and other Lower Middle-Income countries (LMICs).

   For a while after the possibility of a Xi-Modi summit surfaced in public domain, there was also speculation that a major deal involving India’s NSG membership, working of the UNSC subcommittee on designation of global terrorists and OBOR/CIPEC may be in the offing. This speculation was partly fueled by expansive statements/articles in the Chinese Communist Party controlled media. However Indian spokespersons, directly or indirectly, soon dampened such speculations, and tried to focus it on broader issues and understanding. It soon became clear, that even a restatement of previous agreements and understandings, by a leader who was positioned to lead China for the next couple of decades had a value in itself.

Wuhan Summit

   The informal summit between President Xi and PM Modi was held in Wuhan on April 27-28, 2018.[ix] There were two noteworthy announcements:
(1) On giving “strategic guidance to their respective militaries to strengthen communications in order to build trust and mutual understanding and enhance predictability and effectiveness in the management of border affairs” or in China’s terse words, “strengthen confidence building measures and enhance communication and cooperation to uphold border tranquillity,” Some observers have read a lot into the non-mention of “Strategic guidance in the Chinese version of the summit discussions. This is likely due to the sensitivity of these words for the communist party and its internal institutional management (E.g. the implication that either such guidance from the CMC & its leader was absent earlier or that despite existence of such guidance it was unimplemented is unacceptable to the party leader).

   This is an attempt to fill the gaps in understanding and in communications that were observed during the Dolam crisis, and to extend the border management procedures already operational at the LAC to border areas such as the Trijunction, not traditionally part of the LAC. The underlying objective for India is to minimize the probability of a hot war through accident, mistake, misunderstanding or misjudgment (of our capabilities). Apparently China and its leader are equally interested in this objective at the current juncture, when it its confronted with several challenges on economy, trade, N Korea, Taiwan and South China Sea.

(2) The agreement to do a joint economic project in Afghanistan to “open new areas of cooperation “

     Afghanistan is a country in which China and India have some overlap of interest, namely to keep it from becoming a base for Jehadi Terrorism. Both India and China have some advantages and limitations/constraints in Afghanistan. India has a clear economic & social advantage based on its labor n term relationship with the Afghan Govt & people. It’s major limit is access. China on the other hand can provide security for its projects, through its influence with the Pakistan Army & its terrorist network! A joint project in Afghanistan can minimize each other’s constraints for mutual benefit. It also provides an opportunity to develop a better understanding on cooperation in anti-terror and infrastructure, by working together on an experimental basis.

Neti Neti

      Given the vast amount of misinformation, misunderstanding and baseless speculation, it’s also important to state what this summit was not about and did not do. The summit was not about India-China trade imbalances, economic cooperation in India or River flows. It did not discuss/resolve the issue of China’s veto of India’s NSG membership or our objections to OBOR (the term still used in Chinese). It doesn’t change the time line of China-Pakistan alliance, which has been developing for 30 years, and accelerated a decade ago with the agreement to develop Gwadar into a Chinese logistic naval base disguised as a commercial port.

    The agreement to explore cooperation in Afghanistan is not (repeat not) the first step towards “joining” OBOR. Unlike AIIB or any other formal institution, with rules, regulations and institutional structure, OBOR is whatever China defines it at any given time: Its just a post-hoc collection of projects, motivated by excess capacity in China, attempt to grab the diplomatic initiative from the established powers and a National security strategy disguised as a commercial initiative.[x]

Conclusion

    The Wuhan summit does not change India’s understanding of the medium-long term strategic challenge from China. It merely provides breathing space for us to up our development of border infrastructure, fill basic gaps in defence production such as ammunition and to replace outdated defence equipment. It gives us some breathing space to get our own house in order, in terms of border infrastructure, shortage of and foreign dependence on ammunition, reform of the National security structure (a la DPC) and pending, excruciatingly slow decisions on Security partnerships with the USA & other countries.  

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[i] Difference between Strategy (https://www.merriam-webster.com/dictionary/strategy ) and Tactics (https://www.merriam-webster.com/dictionary/tactics ).

[ii] Virmani, Arvind, “Foreign Policy Under PM Modi, Policy Paper No. WsPP 4/2015, N Delhi, May 2015.  https://docs.google.com/viewer?a=v&pid=sites&srcid=ZGVmYXVsdGRvbWFpbnxkcmFydmluZHZpcm1hbml8Z3g6M2M2ZWZkMTg3NTU5MWYzMQ . Virmani, India, “India's National Security Doctrine: An Approach”, June 24, 2016 https://docs.google.com/viewer?a=v&pid=sites&srcid=ZGVmYXVsdGRvbWFpbnxkcmFydmluZHZpcm1hbml8Z3g6MTZjODVjZDg5ZmM2MTJjZA .

[iii] Dalai Lama reaches Tawang - The Hinduwww.thehindu.com › article17866681 )

[iv]  How India should respond to China's response to Dalai Lama visit to Tawang - Business Line, https://www.thehindubusinessline.com › ... )

[v]  https://en.m.wikipedia.org/wiki/2017_China–India_border_standoff .

[vi]  Doklam Standoff-China Violates agreements with India and Bhutan » Indian Defence Review www.indiandefencereview.com › spotlights , Why China's Legal Claims for Doklam Are Weak  https://www.brookings.edu › 2017/08 › c... ).

[vii] Doklam standoff ends as India, China step back - The Hinduwww.thehindu.com › article19577183

[viii]  https://www.facebook.com/arvindvirmani2/posts/944178702416051

[ix] India-China Informal Summit at Wuhan - The Ministry of External Affairswww.mea.gov.in › press-releases › India...

[x]  http://dravirmani.blogspot.in/2016/06/obor-economic-diplomatic-and-strategic.html