A Long Watch
The uncertainties of 2016 linger and things will only get worse before they get better
THERE IS AN ENDEARING naiveté to the belief that humans are so predictable that one can forecast their collective behaviour a year in advance. Economies, like Newtonian objects, do not change momentum without new forces being applied, making predictions somewhat tricky, particularly as major forces are generally not known in advance. As we saw in 2016, unexpected developments across the world (demonetisation, Trump and Brexit, to name a few) not only shook up conventional thinking, forcing analysts to revisit the first principles of economics and politics, but also left all forecasts made last year in the dust. And yet there is some value in looking through the windscreen.
The first ‘forecast’ for 2017, however unhelpful for those desirous of clear visibility, is of significant policy uncertainty. The momentous changes of 2016, both local and global, have not played out fully yet, and the earth passing a certain point in its orbit around the sun does not change much.
Locally, it is far from clear that the government is done with its fight against black money—changes in the budget or continuing administrative measures to improve tax compliance could impact the course the economy takes. At a more basic level, the feeling of being disoriented is generally not good for markets and for investment plans. The beginning of GST could also be disruptive: positively for some industries and enterprises and negatively for some others. But who gets slotted in which basket is still uncertain, as it is unclear which items would attract what GST rate, the detailed rules that need to be followed, as well as administrative division of work between Central and state governments. One can also not be sure of the political response to the UP election verdict in March, as the election itself could throw surprises. It is the most important state election for the ruling party after the Bihar elections in December 2015, and could also affect the behaviour of Opposition parties. Globally, as the new and somewhat unorthodox administration in the US takes over, major changes are expected on several fronts that impact India, from geopolitics and trade to the interest rate trajectory, energy prices and global currency movements. These are likely to trigger second-order effects, as other governments and central banks respond to a somewhat radical departure from the status quo. In Europe, the triggering of Brexit, as well as the upcoming elections in France and Germany, could similarly affect visibility of government and central bank policy. In China, while there is little uncertainty with regard to the re-election of the current leadership due in the second half of the year, the government’s support to economic growth may change after the re-election.
There are also several trends from 2016 that are likely to persist in 2017. For starters, the economic turmoil caused by demonetisation could last several quarters after currency availability has normalised. There are several drivers of this disruption, which could get accentuated by the beginning of GST sometime in calendar year 2017.
Firstly, the real estate market was the preferred repository for black wealth: this is the reason India has the lowest rental yields in the world despite high interest rates (i.e. if you invest Rs 100 in a fixed deposit, you get Rs 7 every year, but if you buy an apartment and put it on rent, you get only Rs 2). Even if temporary, the slowdown in black money creation is likely to slow down real estate transactions and build pressure on prices. Already, new launches seem to be happening at meaningful discounts, and search queries for new home purchases have fallen sharply. As real estate is 13 per cent of India’s GDP, a slow real estate market hurts overall economic growth. Further, the negative wealth effect triggered by declines in house prices can also hurt discretionary consumption.
Secondly, India has a large informal economy: the Central Statistical Organisation reports that 45 per cent of India’s GDP is informal. Most of this activity relies on cash-based credit and cash transactions, which have been meaningfully disrupted. These may take a long time to revive, or to switch to non-cash mode/ formal credit wherever they can. Some of these business models are built on tax avoidance, and may not survive if forced into the tax net. Such disruption, while healthy in the longer run, as it provides an opportunity for the formal enterprises to gain share, will hurt demand in the near term.
Thirdly, the banking system, which has been at the forefront of the demonetisation exercise, has had its control processes stress-tested in the last two months, as transaction volumes skyrocketed. There have been media reports of meaningful control breaches, and active connivance by some employees in money-laundering. As the banks embark on intense internal audits and handle government pressure to penalise errant employees, they will be distracted from the main job of lending productively. Further, a slowing economy could add to the pile of bad loans, and this time in a more destabilising way. In the past few years, the banking system has been plagued by bad loans to large corporate groups. While these loans have proven hard to resolve, they had two advantages from the perspective of systemic stability: there was no contagion effect as the set of firms in trouble was not expanding, and senior management of the banks could talk to these large borrowers and ‘manage’ the loans from turning bad. This current slowdown is likely to create a new crop of bad loans, which will not have both these characteristics. There could be cascading defaults, for example, as trouble in the informal system topples an enterprise that had borrowed from banks, and which in turn could create trouble for some other borrower. Further, banks would struggle to ‘evergreen’ such loans, as allowing branch managers to negotiate with borrowers runs the risk of branch-level corruption. Such losses would thus precipitate quickly, and add to the slowdown.
Lastly, a slowing economy is likely to mar tax revenues both at the Centre as well as states; a slowing real estate market could also hurt states’ stamp duty revenues, especially painful in states like Maharashtra and Uttar Pradesh, which greatly depend on them. In particular, under GST, the Centre’s fiscal balance may come under pressure, as it has promised state governments that they are to be compensated every quarter if their revenue grows less than 14 per cent. Given the necessity to stimulate the economy as private sector investment remains anaemic, these burdens become an overhang.
THERE IS ANOTHER CONTINUING trend from 2016: meaningful agricultural surpluses pushing down food prices. Growth in India’s food demand has slowed with slowing population growth and a flattening curve for per capita calorie consumption. However, agricultural productivity continues to rise, and surpluses are emerging across food categories. The protests for reservations in the last two years by primarily agricultural land-owning communities were attributed to the drought, but the root cause was excess supply. Recent demonetisation-driven disruptions in the perishable supply chain could cause some shortlived stresses in the coming year, but the medium-term trajectory is likely to be of lower food prices, keeping agricultural income growth muted after a decade of doubledigit increases. As farmers mechanise to retain profitability, more workers are likely to move out of agriculture, further intensifying the job creation problem for policymakers.
Most of these trends, if managed well, can sharply improve India’s mediumterm growth outlook. A stalled real estate market, where prices had gone too high, had slowed down construction. The decline in real estate prices can be disruptive while it is on, but the fall could allow more genuine buyers to step in (India needs substantially higher housing stock). The resultant increase in volumes can boost economic growth. Similarly, GST and demonetisation are disruptive in the short run but can lift India’s tax-to-GDP ratio, breaking it out of a vicious cycle of low taxes driving a small government. That in turn increases informality, reduces productivity and thus drives low taxes, completing the vicious cycle. Improving agricultural productivity is also good: when the rest of the world is worrying about competing with artificial intelligence and robots, that nearly half of India’s workforce is still in agriculture is an embarrassing statistic. But somewhat like during the renovation of a house, one must live through several quarters of dirt and noise before the new and better structure becomes visible. NEELKANTH MISHRA is India Equity Strategist for Credit Suisse
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