India: Moving beyond demonetization into a new fiscal year Global Economic Outlook, Q2 2017

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​Despite global uncertainty and demonetization, India’s growth remained buoyant for three-fourths of last year. Looking ahead, strong economic fundamentals, improving prospects for faster reforms, and growing digitization bode well for business optimism and economic activity.


For the first time in almost a decade, global growth is likely showing signs of “green shoots,” suggesting that the world may be witnessing a synchronized recovery. A coordinated global recovery bodes well for India, as it steps into the new fiscal year this April. This might give the economy the opportunity to increase investment and exports, which have remained a concern in the past year. Undoubtedly, the economy exhibited immense resilience in the first three quarters of fiscal year (FY) 2016–17 despite weak global growth, increasing global uncertainty, and, more importantly, the government’s demonetization move in November 2016. However, growth has remained lopsided, with domestic consumption doing most of the heavy lifting. A prudent budget for FY 2017–18, accompanied by supportive monetary policy, improved prospects of a faster implementation of reforms by the government, and a possible rise in digitization, could help India achieve an all-inclusive growth.

A coordinated global recovery bodes well for India, as it steps into the new fiscal year this April.

Did India leapfrog the impact of demonetization?

GDP growth in Q3 of FY 2016–17 was surprisingly buoyant, at 7.0 percent year-over-year. Not only was growth significantly above market expectations, the second advanced estimate of GDP by the Center Statistics Office (CSO) for the current fiscal year was 7.1 percent, the same as the one it had published before the budget, without accounting for the impact of demonetization.

While the numbers left many baffled, a deeper dive shows the currency ban did impact economic activity; it also influenced the Reserve Bank of India’s (RBI’s) policy decisions thereafter and the government’s union budget for FY 2017–18, announced in January 2017. However, as the dust continues to settle six months after demonetization, a tangible long-term benefit of the process appears to be emerging: a gradual move toward a digital economy.

Explaining the rationale behind solid growth

Data releases for a few high-frequency indicators, such as the purchasing managers’ index composite indicator, industrial production (IP) index, and auto sales, in November and December suggested that production and consumption demand bore the brunt of the cash crunch, as was expected. Growth in Q3 of the current fiscal year (October–December 2016) was expected to be sharply hit, pulling down growth for the entire fiscal year. Hence, the economy’s surprising resilience left the market and analysts wondering where the negative impact of demonetization showed up.

Analysis shows that demonetization did have some impact on GDP, but not as much as high-frequency indicators suggested:

  • In January, the International Monetary Fund estimated growth to slow down by 1.0 percent in FY 2016–17 because of the sudden cash shortage and payment disruptions, leading to a temporary negative consumption shock and supply chain interruptions. The two accounts of GDP do contain evidence of lower consumption and production in Q3 relative to the previous two quarters. Total expenditure was 0.3 percent lower than in the first half of FY 2016–17 (Q1 and Q2 together) but 0.6 percent lower without accounting for government spending. Again, gross production was 0.2 percent lower relative to the first half of FY 2016–17, while non-farm-sector production declined 0.7 percent. In other words, not only did growth lose momentum in Q3, but, without the strong growth in government spending and the farming sector, the negative impact of demonetization would have been greater.
  • The other reason for GDP understating the impact of demonetization is that its estimation doesn’t precisely include informal sectors of the economy, which might have been affected the most due to cash shortages.
  • GDP estimates were revised up for all the last six quarters starting Q1 FY 2015–16, except for Q3 FY 2015–16, which was revised down (table 1). In other words, the economy was performing stronger in the first half of FY 2016–17 than was previously estimated. However, the annual growth projection remained unchanged (at 7.1 percent), indicating that the economic activity in Q3 lost its momentum. While 7.0 percent growth in Q3 doesn’t seem so bad (relative to 7.3 percent in the first half of FY 2016–17), the year-over-year performance would have been 6.2 percent absent the downward revision in Q3 FY 2015–16 output.
  • Because of the lack of primary data every quarter, quarterly estimates for production and output are based on extrapolations of annual estimates. Industry output estimates are then compiled by extrapolating the value of output or value added with relevant high-frequency indicators using the benchmark indicator approach. However, because of extrapolations, estimates often fail to reflect ground realities. As more data feeds come in over the next few months, further downward revisions are a possibility.

GDP often misrepresents economic activity estimates because it includes net indirect taxes, as opposed to the production side of the economy (gross value added, or GVA), which is a firmer estimate. GVA, which accelerated over 8.0 percent in the first half of FY 2016–17, grew 6.6 percent in Q3 FY 2016–17. The second advanced estimate of GVA by CSO was revised down by 0.3 percentage points to 6.7 percent (as opposed to no change in GDP estimate) for the entire fiscal year, and is lower than the previous fiscal year’s GVA growth of 7.8 percent (table 1).

Comparison of GDP and GVA estimates before and after revisions

Monetary policy dilemma

A year ago, the RBI faced the challenge of tightened liquidity, given a deficit in interbank liquidity over several quarters and a sharp rise in the short-term bill above the repo rate (figure 1). The pressure on prices was easing as well due to falling commodity prices and expectations of a better monsoon in 2016. Consequently, in its April 2016 policy review meeting, the RBI cut policy rates by 25 basis points. It also changed its liquidity framework by progressively lowering the average ex-ante liquidity deficit in the system to a position closer to neutral in order to increase liquidity.

A year later, the situation has completely reversed. The RBI now faces the challenge of managing excess interbank liquidity as demonetization led to a strong rise in deposits and reduced cash withdrawal (even after the removal of withdrawal limits after March 13, 2017). Consequently, yields on short-term bills have fallen below the repo rate (figure 1)—similar to what happened in 2009–10.

At the same time, there are upside risks to the baseline inflation projection this fiscal due to uncertainty surrounding the upcoming monsoon and its impact on food inflation, the one-off effects of the goods and service tax (GST), and rising inflation in advanced economies. Low commodity prices might partially offset the impact, but high oil price volatility brings uncertainty. The RBI had noted this in the monetary policy meeting held in February 2017 and changed its monetary policy stance from “accommodative” to “neutral” to achieve the medium-term target for consumer price index (CPI) inflation. That said, the availability of funds to industries and credit lending conditions have eased in the past year, and will likely continue to do so.

Short-term Treasury rate yields have dipped below the repo rate owing to high liquidity

In its April 2017 policy review meeting, the RBI kept the policy rate unchanged (as expected) due its cautious view on inflation. At the same time, it narrowed the liquidity adjustment facility (LAF) corridor to contain the fall in short-term yields owing to high interbank liquidity. However, the RBI didn’t announce any specific move to reduce this liquidity. In its April 2017 policy review meeting, the RBI kept the policy rate unchanged (as expected) due its cautious view on inflation. At the same time, it narrowed the liquidity adjustment facility (LAF) corridor to contain the fall in short-term yields owing to high interbank liquidity. However, the RBI didn’t announce any specific move to reduce this liquidity.

Beyond demonetization

In line with our expectations (expressed in our previous Global Economic Outlook article “India: The pains and gains of demonetization1), demonetization did have an impact on economic activity in Q3 and, possibly, Q4 as well, in addition to policy decisions. At the same time, there is evidence that the impact is likely to be transient and might not spill over into the next fiscal year. High-frequency indicators that were hit hard following demonetization have started showing signs of recovery since the beginning of this calendar year. In January, the IP index surged sharply by 2.7 percent, while the subindex for capital goods recorded a staggering 10.7 percent growth after several months of contraction. Overall automobile sales also reported an increase of 1.0 percent in February, after touching a 16-year low in December 2016.

In addition, there are signs that India is slowly transitioning toward a digital, cashless economy. In the past four months, digital transactions have gone up significantly, as shown in figure 2. The government has also tried to promote digital transactions in various ways, launching new digital apps, unstructured supplementary service data, and a dedicated television channel to educate people about cashless transactions. However, the permanency of this digitization trend remains in question at this point of time, given the majority of the Indian population’s digital illiteracy and fondness for cash. Also, there is always skepticism about the rise in cybercrime that might follow increased digitization.

There are signs that India is slowly transitioning toward a digital, cashless economy.

A rise in digitization in the economy

Economic fundamentals continue to remain strong. The massive victory of Prime Minister Narendra Modi’s political party, Bharatiya Janata Party, in Uttar Pradesh’s state election, and the party forming the government in Goa and Manipur have boosted the government’s prospects of implementing reforms at an accelerated pace. These will likely go a long way in improving business confidence and India’s attractiveness to global investors. The fact that foreign direct investment (FDI) inflows are stronger and the Indian rupee has somewhat appreciated in the past few months despite the two policy rate hikes by the US Federal Reserve and rising trade protectionism across the globe are evidence of the economy’s resilience.

According to a Deloitte CFO annual survey conducted in India recently (forthcoming), business optimism has increased tremendously over the medium to long term relative to the past year, and businesses are now more willing to undertake business risks and investment in the coming years.

A note on the current budget

Our India article in last quarter’s Global Economic Outlook did not discuss the budget analysis because of the timing of the publication. However, not discussing the budget while deliberating about India’s outlook would be telling only part of the story. So here are some highlights of the budget.

The government demonstrated confidence in its current approach and schemes, and announced a well-balanced budget in January 2017 for FY 2017–18. While showing restraint by not giving in to the constant demand by the opposition and market for a large stimulus to boost consumption in the wake of demonetization, the government did focus on the sections of society most affected by the move. Proposed measures in the Union Budget 2017 include allocating the highest-ever amount to the Mahatma Gandhi National Rural Employment Guarantee Act; granting infrastructure status to affordable housing that could lower tax rates and, potentially, funding costs; reducing corporate tax rates only for small and medium enterprises; and reducing the existing rate of personal income tax from 10.0 percent to 5.0 percent for the lowest income-tax slab. These measures are expected to boost the purchasing power of the lower- and middle-income population.

In addition, the government expressed its commitment to reduce the fiscal deficit by adhering to the recommended fiscal road map. This was despite its intention to implement the goods and services tax (GST) this year. However, there are upside risks in reaching the stated target of 3.2 percent of GDP. State finances have been deteriorating and are expected to worsen with the implementation of the GST, which will likely put pressure on states’ fiscal budgets because of uncertainties in tax collection and compensation to states. Moreover, the impact of demonetization on growth may result in an increase in pro-cyclical government spending.

The finance minister announced the phasing out of the Foreign Investment Promotion Board in 2017–18. Further liberalization of FDI policy is under consideration. High-quality foreign portfolio investors also received clarity on how indirect transfers of shares would be taxed. These measures will likely ease processes for FDI into India and improve conditions for doing business.