Indian economy still coming to terms
By Chief Economist, Taimur Baig and Economist Radhika Rao.
A year after the government of India scrapped high denomination currency notes (around 80% of currency in circulation), a wide range of indicators suggest the economy is still coming to terms with it. While the initial scene of long lines to exchange notes disappeared within a month or so, the shock measure left a rather lasting impact on informal economic activities, bank deposits, and digital transactions.
We see demonetisation as one of many measures taken in recent years by the authorities to nudge Indians toward formalised economic activities. An economy where proceeds from activities can be tracked is one where the tax base is bound to expand and malfeasance is harder to hide. Other measures might not have been as dramatic as demonetisation, but targeted cash subsidies, financial inclusion, e-governance, universal ID, and the latest, registration of businesses under goods-and-services tax, all aim to bring Indians’ income-generating activities out in the open.
In an economy where 90% of employment and over 50% of GDP is derived from informal activities, this is bound to be a highly disruptive process. Without adequate social safety net provisions, the inevitable rise in the cost of operating in the formal economy (entailing registration, tax compliance, and regulatory obligations), will likely compel many informal businesses to either restructure or perish.
Since wage and income data from India’s informal sector is not well covered, the inevitable adjustment forced by formalisation may not show up in most reported data. We therefore look for corroborative evidence on how much adjustment has already taken place, and what is left.
Considering that the economy is undergoing a multitude of reforms, it is sometimes difficult to distinguish the impact of demonetisation from the rest (for example, GST stipulations, introduced in July, must have had some consequences for margin, profitability, and activity). With that caveat in mind, the data on two-wheeler sales, demand for public works, and credit to SMEs are perhaps the best we have in understanding how the currency swap programme has shaped the economy over the past year. We are more comfortable analysing the impact on the financial sector, given the abundance of data.
Monetary and financial indicators
India’s money markets and financial system reacted instantly to demonetisation. Bank deposits surged, leading to a spike in reported domestic liquidity, which overwhelmed the Reserve Bank of India’s (RBI) absorption efforts, pushing the rate curve lower and prompting banks to trim deposit/ lending rates.
Before the note ban, currency with the public grew 16% (YoY) between January and October 2016. After the ban, it plunged 44% (YoY) in November-December 2016, signalling acute shortage of cash.
Trends have since improved, as the RBI removed cash withdrawal limits by February-March 2017 and stepped up supply of new notes. In nominal terms, currency with the public is now back at 90% of pre-ban levels (see chart).
Concurrently, strong deposit growth turned the liquidity balance from neutral in October 2016 to a strong surplus of INR4-5trn by March 2017. This excess liquidity pushed down overnight rates sharply, along with easing bond yields.
To correct this imbalance, the central bank raised the reverse repo rate in April 2017 to lift money market/ call rates to the repurchase rate. Additional liquidity absorption measures were introduced alongside regular tools, which included market stabilisation bonds and regular bond sales through open market operations (INR800bn so far). These, however, came at a cost.
RBI’s earnings took a hit due to a jump in costs associated with demonetisation and liquidity-absorption measures in FY16/17. Total income was down 24% while expenditure surged. Costs associated with currency printing rose 130% in FY17, as four-fifth of the monies in circulation had to be replaced. These led to a halving in RBI dividends paid to the government, hurting the latter’s non-tax revenues this year.
Subsequently, liquidity conditions have tightened as the surplus fell below INR1trn and absorption efforts might continue till the balance is back to neutral (see chart).
Assessing the response of the real economy
Impact on economic activity was broad-based and prolonged, but with varying intensities across sectors. Cash-dependent service sectors, like transportation, logistics, real estate, retail etc. took a greater hit than the larger/ listed entities. Rural demand was depressed, given its cash-intensive nature, while the switch to digital payment modes helped mitigate the impact on urban demand. Pain was likely most acute on the informal sector, data for which is unfortunately patchy.
Real GDP growth slowed to 7% (YoY) in the December 2016 quarter vs 7.7% in April- September. The slowdown was not as sharp as feared. Just as markets patted themselves on their back, growth in the March 2017 quarter eased sharply to 6.1% on slower consumption, investments, and services growth. Moderation continued into the June quarter, with growth slowing to 5.7%.
Looking ahead, while the bulk of the note ban-driven pain is likely behind us, households and businesses are still to return to normalcy. This adjustment period was interrupted by the concurrent implementation of GST.
The September 2017 quarter should have gotten a respite from restocking of inventories and festive demand. This might have moderated into October-December 2017, inferring from incoming PMI, auto sales, and sentiment surveys. For FY18, we forecast annual real GDP growth at 6.8% (YoY), a three-year low.
Recovery in the informal activity is likely to be delayed, given the pain inflicted by two big-ticket changes within a short period of time (demonetisation and GST). We track two-wheeler sales, employment generation under the Mahatma Gandhi Rural Employment Guarantee (NREGA), and credit growth to small- and medium-sized businesses, as indicators:
Two-wheeler sales dipped sharply in the wake of the note ban (see chart above), but the trend improved into 2017. We reckon that pre-GST destocking and discounts also helped lift demand from lows.
An increase in demand for work under the NREGA is a gauge of stress in the informal sector. A study by the Economic Survey observes that there was a clear increase in demand for work in the four weeks after demonetisation than the preceding four. This was particularly strong in the less-developed states such as Bihar, West Bengal, Rajasthan, amongst others. We also note that the total expenditure under the NREGA program jumped in FY17, mainly on higher wage payouts and is likely to remain high in FY18.
Banks’ credit growth to small- and medium-sized businesses has been in negative or low single-digit growth in recent years. While supply of funds was likely constrained by tighter lending standards (in the midst of stressed banks’ balance sheets), demand was depressed by difficult operating conditions.
Demonetisation, followed by the GST rollout, likely worsened conditions for these firms. Recent GST fine-tuning measures should provide a respite through lower compliance costs, freeing up working capital and easing the tax burden.
Effectiveness: mixed signs
The first volume of the Finance Ministry’s Economic Survey cited three markers which help determine the success or effectiveness of the demonetisation exercise: a) changes in the use of digital payment methods, b) a decline in the cash-to-GDP ratio, c) expansion of the tax base, and we add, d) addressing the black/ unaccounted money problem.
Firstly, usage of digital payment modes has increased, even if the pace has moderated since the post-demonetisation surge. Combining three e-payment tools (retail payments, credit cards, and prepaid instruments), usage rose 44% (YoY) in Q1 2017, but has since moderated to 30% in volume terms. Value of transactions is also off highs. Payments through Rupay (a domestically issued credit card) also experienced a similar trend.
This suggests that the shock-and-awe effect of the demonetisation initiative has pushed users towards digitalisation, though to retain the momentum, supportive efforts – improving the digital architecture/ backbone, cybersecurity framework, developing Aadhar adoption, ensuring internet and telephony connectivity, financial inclusion efforts, and better investor education – are equally necessary.
Secondly, the cash-to-GDP ratio has eased, suggesting a reduction in hard-currency stock held by residents. From ~12% of GDP in FY16, the ratio fell to 8.3% in FY17 and has since risen to about 9.5% in the first few months of FY18. This points to a circa 2% of GDP drop in cash holdings, which is now being parked in bank deposits (see chart on right).
Next, widening the tax base and increased formalisation of the economy was another benefit sought from demonetisation. The income taxpayer base has reportedly widened to 62mn by FY17 from 40mn in FY16, according to the Central Board of Direct Taxes, cited by the press. Compared to a 25% increase in new taxpayers in FY16, FY17 recorded a jump of 45%, according to the Economic Survey. We suspect that these numbers also reflect the impact of the Income declaration schemes that were announced following the demonetisation scheme. Rollout of the GST is also expected to bring more businesses under the tax umbrella, marking a step towards formalising the economy.
Finally, we gauge whether the measure helped curb the usage of black/unaccounted money. As we write, the official count of returned notes to the commercial banks/ RBI is pending.
The RBI’s FY16/17 Annual Report provided some insights. It estimated that about 99% of the value of total notes scrapped in November 2016 had returned to the banking system i.e. of INR15.45trn withdrawn, INR15.3trn was back. The volume of counterfeit notes collected saw a 20% jump, but was negligible in value terms. There was a five-fold increase in the number of suspicious transaction reports filed with banks. A sample study into fake currency detection saw an increase last year vs prior years, albeit marginally.
While the final count is still awaited, we believe that the push to arrest the usage and circulation of black/unaccounted money requires a broader cohesive framework to improve checks and balances in the system. Demonetisation marks a step in this direction, with transactional data trails (through information on large deposits, tax liabilities, income records etc.) likely to provide useful inputs for the tax and legal departments. Benefits due to higher due diligence, a wider tax net through income declaration schemes, and discouraging cash transactions were more palpable in the short term.
Looking ahead
We view the note ban as one of the larger pool of measures aimed at enhanced formalisation. This includes pushing forth the biometric identification scheme, tighter regulatory/legal checks, transparency in tax transactions, monitoring money held overseas, amongst others. We are convinced that as more individuals and businesses join the formal sector, it would help broaden the tax base, reduce illicit transactions, and create a more enabling environment for regulated activities. Ultimately, this will provide for worker protection, a bigger revenue base for the government to invest, and a more level playing field among businesses. But in the near term, a deep consolidation in the informal sector appears inevitable. This is bound to remain a drag on growth in the coming quarters. fii-news.com