A Long Watch

The un­cer­tain­ties of 2016 linger and things will only get worse be­fore they get bet­ter

India Today - - BUSINESS & ECONOMY -

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


Illustration by ANIR­BAN GHOSH

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