As the impact of demonetization is debated, the World Bank projects a return to 7%-plus GDP growth.
The article was first published in GARP Risk Intelligence, July 14, 2017; Co-Author- Anisha Sircar
India’s gross domestic product growth rate fell to 6.1% in the March quarter, the final quarter of the 2016-17 fiscal year. The slowdown was not unexpected; it was merely a matter of how much. GDP growth was 7.3% in the first half of the fiscal year (April to September 2016) and 7.0% in the October-December period.
All of these numbers are below the 7.9% GDP growth of the previous, 2015-16 fiscal year, when India was the fastest growing economy in the world, according to the World Bank’s May 2017 India Development Update.
In a country where about half the population is dependent upon agriculture, and where agriculture is, in turn, largely dependent on the monsoon rains for irrigation, the economy seemed to be poised for even better growth, with heavy monsoons this year resulting in higher consumption-driven demand.
Therefore, the fourth quarter GDP data did not sit well with most economists and critics of the Narendra Modi-led government. It had demonetized high-value Rs500 and Rs1000 currency notes in November 2016, in an attempt to root out black money in India. Eighty-six percent of the country’s currency was demonetized at one go.
Critics claimed that the demonetization was a vain exercise that resulted in significant inconveniences, delivered a massive blow to the unorganized sector that is largely cash-driven, caused jobs losses, and regressed the overall economy.
Weighing the Impact
Government agencies maintained that the impact of demonetization on growth would be temporary, as GDP data does not encompass the entire health of the economy, or the total effects of demonetization. This is particularly significant because demonetization is estimated to have affected the informal sector of the economy – that which is neither taxed nor regulated – more than the formal sector. The 7% GDP figure for the third quarter suggested that the economy was almost unaffected by the demonetization experiment.
Prof. Arun Kumar, an expert on India’s black economy, writes in his recently published book, “Understanding the Black Economy and Black Money in India: An Enquiry into Causes, Consequences and Remedies,” that demonetization “created great economic hardships for many millions, and disrupted the economic momentum the country had hitherto succeeded in building up . . . The black money the government was targeting is only 1% of the black wealth held in the country, and even if the government managed to suck out all the black cash in circulation, it would not have much effect on the black economy which involves various activities in which black incomes are generated. It does not stop these activities from continuing.
“Moreover, 80% of the Rs500 and Rs1000 notes was not black money, but rather white money used by businesses and citizens. The biggest fish were able to quickly convert whatever black cash they had into white . . . [Also] it was not explained why, when high currency notes were being demonetized, currency of even higher denomination, i.e. Rs2000 notes, were being introduced – as this would be even easier to hoard.”
Can we therefore conclude that demonetization is to be blamed for the slowdown in the GDP growth rate? A closer look suggests that the economic slowdown began before the demonetization. GDP growth in the second quarter was lower than GDP growth in the first quarter, and other indicators such as the gross value added (GVA) were also revealing.
GVA is the value of goods and services produced in terms of output, minus intermediate consumption, that is, GVA = GDP + subsidies – taxes. In simple terms, it is output, as measured from the supply side of an economy.
Tax and Inflation Factors
The increased sales tax collection translates into higher net indirect taxes (NIT), accounting for a significant gap between GDP and the lower GVA. The recent growth in tax receipts, particularly from fuel and metal, was a factor in the difference. Even when global oil prices were on the rise throughout the year, India did not cut excise duties on petroleum products, and customs duty receipts on imported metals increased because of higher commodity prices.
With the rise in commodity prices, and latent demand becoming rendered after the currency was re-monetized, another factor that came into play was inflation. Its rise contributed to lowering GDP and GVA even more in the fourth quarter.
When demonetization was at its peak, the wholesale price index (WPI) inflation rate stood at 1.8% and 2.1% in November and December 2016, respectively. WPI inflation rose dramatically following re-monetization, from 5.25% in January 2017, to 6.55% in February 2017 – its highest recorded figure in two and a half years. This increase was attributed mineral and fuel prices.
Consumer price index (CPI) inflation went from 3.17% in January, two months after demonetization was announced and just as food prices began picking up, to 3.65% in February. (Re-monetisation, it seems, picked up the pace for consumption-driven demand as well.)
The sudden surge in inflation accentuated worries of a latent, untapped nexus of demand caused by demonetization. However, more recent inflation figures reveal that notwithstanding the slight optimism in GDP numbers, inflation rates began falling to multi-month lows in May, due mainly to a rarely seen drop in food prices. In April, CPI reached a historic, multi-year low of 2.99%, compared to 5.47% in April 2016, due to the deflation in food prices; and WPI dropped to 3.85%, a four-month low.
Macro Indicators Slump
While GDP growth slowed to 6.1% in January-March 2017, from 9.2% a year earlier, the GVA rate went from 8.7% to 5.6%.
The index of industrial production (IIP), used to approximate activity in informal manufacturing, showed healthy growth in the first fiscal quarter (April-June 2016) and then began tapering off. Even investments took a significant hit during the fourth quarter: fixed investment lowered to 25.5%, the lowest in 13 years; and real fixed investment dropped 2% year-on-year. High expectations for foreign direct investment this fiscal year did not revive the private sector; declines in private investment have been setting back employment generation for many years, but the repercussions of demonetization on private investments seem to have worsened this problem.
Overall, in contrast to earlier optimism, the fiscal fourth quarter was harrowing for the Indian economy, uplifted only by government expenditure and, to a lesser extent, agriculture, without which GDP growth would have accounted for only an estimated 4%.
Economists such as Arun Kumar are not so optimistic – they say that not only has demonetization failed to effectively tackle the black-economy problem; it has also hurt the overall economy and the livelihoods of the poor and small traders who depend overwhelmingly on cash.
Aside from the decline in demand across the economy, better-off sectors have also been facing uncertainty, cutting back discretionary expenditure on even “white” goods. All of this, as the figures reveal, has impacted agriculture, services and industry, and will only serve to exacerbate the problem of non-performing assets in banks as industrial profits continue to decline. Since demonetization was announced, unemployment is believed to have risen, investments fallen, and banks and agriculture facing growing crises – all in spite of a good spate of monsoons. Many believe that this could turn the economy toward.
According to the World Bank, India’s fundamentals remain strong and a re-acceleration of GDP growth, to 7.2%, is anticipated in fiscal year 2018. A growth rate of 7.7% is projected for fiscal 2020, attributed to efforts to encourage the recovery of private investment through infrastructure spending and less crowding of the private sector.
The World Bank assessment concludes that in order to heighten the potential for growth, productivity enhancements, larger investments, and increasing the number of women in the labor force of India would need to be implemented.