India: Wiggling through demonetization and GST Global Economic Outlook, Q3 2017

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​India’s economic growth has slowed down, and demonetization is only partly to blame. While the near-term economic outlook remains mired in uncertainty as India transitions to a new sales tax regime, the government’s ability to take on difficult reforms bodes well for the long term.


India’s economic growth seems to be losing steam, as the economy posted weaker-than-expected growth in the fourth quarter of FY 2016–17. According to the latest data on economic activity, GDP grew at an annual rate of 7.1 percent, almost 1.0 percent lower than the previous fiscal year.1 While one might assume that there is nothing surprising about the slowdown and that demonetization is to be blamed for the economy’s poor performance, a deeper dive shows that the economy had started slowing even before demonetization was announced. Post demonetization, the slowdown further intensified, specifically in the fourth quarter of FY 2016–17 as the economy struggled to cope with the cash crunch.

Even as the impact of demonetization gradually phases out, the outlook remains mired in uncertainty for the next few quarters because of the fiscal tightening at the center, the base effect of agricultural growth, stressed assets in the banking sector, and global risks emanating from rising protectionism. In addition, there are concerns that growth and inflation might be impacted in the coming quarters as the economy transitions to a new national sales tax regime—the goods and sales tax (GST) that went live on July 1, 2017.

While one might assume that demonetization is to be blamed for the economy’s poor performance, a deeper dive shows that the economy had started slowing even before demonetization was announced.

That raises questions about the sustainability of the strong economic performance India has been boasting about. Will these impact the long-term growth outlook and optimism about India?

Growth slowly lost steam through FY 2016

GDP growth fell from an annual rate of 8.0 percent in FY 2015–16 to 7.6 percent in the first half of FY 2016–17. It might seem a marginal decline, but much of this growth was masked by very strong agriculture and government spending in the period prior to demonetization. Growth net of these two sectors depicts a very different picture.

Gross value added (GVA) growth on the supply side net of contributions from the agriculture and public sectors (referred to as core GVA) fell from 9.8 percent in FY 2015–16 to 8.1 percent and 6.6 percent in the first two quarters of FY 2016–17, respectively. In other words, growth was evidently slowing even before demonetization. The slowdown further intensified in the second half of FY 2016–17, and core GVA grew 3.9 percent in Q4 FY 2016–17—the lowest growth rate recorded since 2009 (figure 1). While one may attribute the poor economic performance in the second half of the year to demonetization, it is difficult to discern how much of the slowdown was exclusively because of it.

Growth net of contributions from the agriculture and public sectors fell substantially

What is noticeable from the latest data release is that finally there is some parallel between the GDP growth story and the narrative from the past year’s high-frequency economic activity. The new industrial production series had been signaling a slowdown in economic activity since early 2016. On the other hand, low inflation suggested that weaker (rural) demand and a negative output gap (the actual output being lower than the potential output), among other factors, were likely resulting in a poor pricing power in the economy (figure 2). However, this slowdown was not apparent from the GDP data until the latest numbers were released in May.

High-frequency data have been indicating a slowdown since early 2016

Looking forward, a pickup in demand will likely depend on the impact of fiscal consolidation, removal of infrastructure bottlenecks, and the pace of revival of private investment and the banking sector. It might take some time for demand to improve as the impact of demonetization on consumer spending and investment wears off completely. The implementation of the GST might impact activity as businesses cope with the new tax structure. There are upside risks to inflation as food and commodity prices are expected to remain low. However, only the inflation data in the coming quarters can reveal a clearer picture.

The landmark tax reform

The GST—India’s biggest landmark tax reform since independence—went live on July 1 after 17 years of debate, replacing a myriad of central, state, interstate, and local taxes, and uniting the nation with a single tax rate for any good or service across the country. Calling the levy "good and simple tax," the prime minister expressed his hope that the reform will likely herald the economic integration of India, streamline businesses, and boost the economy by tearing down barriers between 31 states and union territories.

As India finally gets rid of segmented markets with different effective tax rates and becomes a common market for all goods and services, it will likely ease the movement of goods and services across the country, reduce transaction costs, and boost allocative efficiency. There are expectations of higher compliance because of the structure it follows, which will likely broaden the tax base and boost tax revenues.

As India finally gets rid of segmented markets with different effective tax rates and becomes a common market for all goods and services, it will likely ease the movement of goods and services across the country, reduce transaction costs, and boost allocative efficiency.

Since all taxes will be collected at the point of consumption, it will include both central and state governments’ taxes. Transparency in taxation will likely deter the government from indiscriminately increasing taxes. In addition, tax revenues are likely to get redistributed from the large producing states to the states with higher consumption, which are also the states with higher population and low per capita income, and which therefore are expected to benefit from such a redistribution of taxes.

That said, when a change of this magnitude is undertaken, there are bound to be some teething troubles and difficulties in the initial stages. Although large-scale businesses are ready for the new tax regime, medium- to small-scale industries are likely to take time to adjust to the new structure. The transition to the GST system may disrupt some businesses’ production plans, and require them to reduce existing inventory and modify their supply chain based on the assessment of tax savings and inventory management costs. This could impact economic activity temporarily as the economy adjusts to a new normal.

The impact of this transition to a national sales tax on inflation and growth remains uncertain. First, it was hoped that the new tax structure would be simple, with a maximum of three tax rates as had been recommended by the Arvind Subramanian committee. However, the current GST has a five-rate structure, plus a potential tax on luxury and “sin” goods.2 This might result in potential disputes over the classification of goods and lead to corruption, thereby reducing ease of monitoring, increasing tax authorities’ discretion, and partially offsetting the compliance and efficiency gains of a simpler structure.

Products of mass consumption have been exempted, while those consumed by the rich are charged at a higher percentage, which might not impact inflation significantly. However, the average burden of tax on services, which accounts for a significant share in consumption, has risen to 18.0 percent from the current 15.0 percent level, which may fuel inflation. However, it is expected that better flow of input credit and improved competitiveness will likely negate the impact of higher rates on services.

In the long run, the new tax regime, in addition to the permanent account number regulations and cash restrictions in business transactions, is expected to impact all businesses and encourage a shift from the unorganized to organized sectors. A simplified tax structure will likely improve the ease of doing business in the country, increase productivity and efficiency in operations, and incentivize foreign investors to invest more. The government is confident that more streamlined businesses due to the GST might boost GDP growth by 0.4 percent to 2.0 percent.3

The long-term outlook is optimistic

Investors are optimistic about the medium to long-term economic outlook. An expectation of a modest but synchronized global economic recovery, strong economic fundamentals, the government’s continued efforts to increase foreign investment inflows, and economic resilience amid global uncertainty have improved business perceptions about risk taking. In addition, with the implementation of the GST, there is growing confidence in the government’s ability to take on difficult reforms in India.

The improvement in investor confidence is evident from capital flows as foreign investors continue to bet on India as one of the promising destinations for investment. Since the beginning of 2017, India has witnessed robust growth in foreign investment (figure 3). Indian businesses, too, have expressed their “heightened optimism” and willingness to take business risks over the medium to long term.4 This bodes well for capital investment growth, which has been trailing for a while.

Foreign investment has been picking up since the beginning of 2017

Willingness to take business risks among CFOs

A prudent monetary policy is likely helpful in the current scenario

The Reserve Bank of India (RBI) kept policy rates on hold, though it hinted at future easing, contingent on the inflation outturn. It revised down its inflation forecasts—the new consumer price inflation rate is expected to remain within the range of 2.0–3.5 percent in the first half of FY 2017–18, and 3.5–4.5 percent in the second half. But, at the same time, the RBI also marked down its GVA growth forecast from 7.4 percent to 7.3 percent.

While it may appear that a rate cut might be prudent to boost the economy and revive investment, which has failed to pick up, the RBI is probably erring on the side of caution. The current health of the banking sector and risks to inflation (although low) are preventing the RBI from taking any premature action at this stage. This is because if a situation warrants a hawkish policy stance in the future, policy reversals later could be disruptive and may result in a loss of the bank’s credibility. Most likely, the RBI will likely keep the policy rate unchanged with a neutral stance for some more time as it keeps an eye on the monsoon and its impact on inflation.