Aggressive economic, tax reform may be hurting India’s performance in short term

It comes as no surprise that Indian business activity contracted sharply after the implementation of a new national tax in July. Questions are being raised about whether the country’s reform program is too aggressive and how long the economic sluggishness will last.

The Nikkei/ IHS Markit India composite Purchasing Managers’ Index ( PMI), which measures both manufacturing and services activity, plunged to 46 in July, its lowest reading since March 2009, from 52.7 in June. The PMI for India’s dominant services sector dropped from 53.1 in June to 45.9 in July, the lowest since September 2013. A reading below 50 points to contraction.

Analysts generally believe that these contractions were caused by the implementation of the Goods and Services Tax ( GST), which led to disruptions to business activity.

The most ambitious tax reform for India in 70 years, the GST is meant to unify the $ 2 trillion economy into a single market, but many companies are still confused about the new system, which is expected to affect sales and production in the short term. Some media reports suggested that demonetization last year was also in part to blame. India’s GDP grew 6.1 percent year- on- year in the first quarter, well below the median forecast of 7.1 percent according to a Reuters report, as a result of the government’s decision in November 2016 to prohibit the use of 86 percent of its cash.

While “iron fist” reform measures seem to have caused the slowdown in India’s economic growth, the real reason may have been the country’s economic fragility. Due to the large amount of bad loans in sectors such as power, infrastructure and steel, India’s banking sector is reluctant to extend new loans these days. That situation directly led to the slump in investment growth by domestic companies, which hit a 25- year low in fiscal 2016- 17, according to media reports.

Since the services sector contributes more than 60 percent of India’s economic growth and the financial sector represents an important share of the services sector, the Indian economy is expected to face pressure amid a scarcity of capital.

Thus there is an urgent need for private investment to propel economic growth, which is why the central bank cut interest rates by 25 basis points last week to the lowest level since 2010. Whether the rate cut can help revive investment remains to be seen.

Hopefully, it will inject sufficient momentum to help the Indian economy sustain its aggressive reform agenda.