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On Financial Year 2017

FY17 will be divided between pre- and post-demonetisation, says Radhika Rao…

DBS Bank economist Radhika Rao says the likelihood of slower growth and the risk that inflation undershoots the RBI target path, the door remains open for a 25 basis points rate cut in the first half of 2017.

The current fiscal year will be divided between pre- and post-demonetisation months in India, says Radhika Rao, economist and vice-president at DBS Bank Ltd in Singapore.

The scrapping of high-value banknotes should be complemented by measures to address structural problems, she said in an interview.

“Benefits of these moves will accrue in the medium-term, while the economy peers into a challenging year ahead,” she said.

Edited excerpts:

You share the view that fiscal 2017 is likely to be seen in two halves—pre- and post-banknote ban. Could you take us through your reasoning?

Fiscal year 2016-17 will be a story of two halves. Growth was 7.2-7.3% in first half of the year—a little slower than last year—and expected to stay apace in the second half.

With the ban, we now expect growth will slow in the second half.

The ban’s impact on the financial markets and liquidity conditions was immediate as deposits surged, overnight rates fell and government bonds yields tumbled.

The economic fallout in the December and March quarters will become clearer in the months ahead.

Growth probably fell below 6% in 4Q16 and, with a modest rebound in 1Q17, full-year growth probably remained below 7%. Much depends on the speed with which currency withdrawal levels are restored, just as tax authorities scrutinize deposits for potential tax evasion and other illegal funds.

A handful of data are available so far. These suggest a disinflationary impact due to weak demand and soft food prices. Manufacturing/services PMIs (purchasing managers’ indices) have taken a knock. Services were affected more, given the dominance of cash-dependent businesses, inter-linked supply chains and the larger role that the informal sector plays there. Auto, cement, real estate and other consumption-linked industries reported weak sales in November-December.

The RBI (Reserve Bank of India) adopted a balanced approach towards these trends at its December review, preferring to wait and see. With inflation undershooting their projections and weak economic output, we reckon that their stance might soften in 1H17.

Policy transmission, meanwhile, got a boost after domestic banks slashed lending rates… Next month’s budget will also be watched with interest where we expect a slower pace of belt-tightening than in recent years.

Advance FY17 GDP (gross domestic product) numbers were announced last week and, factoring in pre-demonetisation data and estimates on the impact of the reform, the CSO (Central Statistics Office) pegged the number at 7.1%, in line with the RBI. Subsequent revisions could trigger a move south to the tune of 20-30 basis points (bps), when the second estimate is available in late February and thereafter on 30 May. (One basis point is one-hundredth of a percentage point.)

We have seen a lot of debate about short-term loss versus long-term gain from demonetisation. What is your take—when will the economy return to normal, at least the transaction part?

Normalcy in transactions largely depends on the speed with which currency withdrawal levels are reinstated. Reports suggest less than half of the Rs14 trillion deposits of the scrapped denomination is back in the system.

If this pace is maintained, then three-fourths should be restored by next month and things should be close to normal by March.

Concurrently, the government is also encouraging a broad push towards digital payment channels and cashless transactions. The banknote ban has been somewhat of a bitter medicine for the economy, especially in the short term.

As discussed above, near-term activity has taken a hit. But if the banknote ban is able to address at least a few of the long-standing ills—curb black money, encourage digital payment avenues and bring the parallel economy into the official fold—then the move is justified.

Hopes are also that increased scrutiny by tax authorities will lead to better tax compliance and widen the tax base. Given the unprecedented nature of the banknote ban, it is not surprising that developments are fairly fluid with ad-hoc changes in play.

Taking a step back, demonetisation should be complemented by other similar measures to address structural problems. Encouragingly, there is an effort to tackle black money within and outside the economy, as tax avoidance treaties with other countries get a re-look and tax loopholes are fixed.

The benefits of these moves will accrue in the medium-term, while the economy peers into a challenging year ahead.

So, post-demonetisation, does India need to rethink how it grows its economy in terms of a fiscal stimulus?

The pace of the remonetisation process will determine how fast things return to normal. While the processes are being streamlined, we don’t expect the government to compromise or renege on other macro improvements achieved in recent years.

Fiscal consolidation is thereby likely to stay a priority, with the targets expected to be met this year and the next. The pick-up in nominal GDP growth in FY17/18 will also help make the fiscal ratios look attainable, despite a wider fiscal deficit in absolute terms.

The FRBM (fiscal responsibility and budget management) committee is also due to table its proposals. If these are adopted, a shift to a range target of 3-3.3% of GDP cannot be ruled out.

Significant changes to the revenue mix are unlikely, despite the need to support growth. We don’t expect an outright cut in personal tax rates, while corporate tax rates are scheduled to be lowered by 5% in the next three years. One-off revenues from the banknote ban might be channelled to fund the late December measures, which included interest sops, rural development spending, loan repayment waivers, etc.

Importantly, much attention is on the quantum of the deficit, but qualitative aspects still need work. High revenue spending, including subsidies and interest payments, make up the bulk of overall expenditure.

Productive/capital spending has been stagnating in recent years, with part of this spending kept off the books. Tax base and buoyancy levels are still low. State and central government deficits cumulatively are more than 6% of GDP, way above its rating peers.

These issues are still to be addressed, thereby lowering the scope of affirmative action from the rating agencies in the near term.

A shift to the GST (goods and services tax) system might also be in the offing in FY17/18. While the move is theoretically revenue-neutral, there is bound to be a buoyancy in fiscal collections. Discussions on the revenue-sharing arrangement between the state and central governments are ongoing, with the former likely to be compensated for the first five years from the implementation. We expect the structural benefits from a simplified and transparent tax system to be seen in the medium-term.

Has demonetisation slowed the momentum in the roll-out of GST?

Demonetisation scuppered the passage of the GST bills in the winter Parliament session. The session proved unproductive as opposition parties pushed for a debate on the currency crunch rather than agree on the GST bills.

A few state governments called for a higher revenue compensation under GST, on fears that their revenues have been affected due to the currency crunch.

The GST is unlikely to take effect by April 2017. Apart from the legislative process, the GST Council must still finalize other details, some of which are contentious. Concurrently, the procedural aspects, investor education, accounting, payment architecture, etc., also need to be streamlined by the second half of FY17/18.

What are your thoughts on the rupee that is currently at 68 versus the dollar? What is your outlook 2017 for the rupee?

DBS believes 2017 currency risks owe more to external factors than internal factors. Expectations of US rate hikes are key here. We expect four hikes in 2017, and this will keep the dollar strong and the Asian currencies weak versus the dollar.

The rupee is unlikely to escape this fate. During the Trump-led dollar rally in November, USD/INR tested a record high, last seen during the height of emerging market volatility in August 2013.

Higher US interest rates seem likely to lower the yield carry advantage of the rupee. Concurrently, it does not bode well that India’s growth will be moderated by demonetisation over the next few quarters. We expect the rupee to test the 70 per dollar mark by second half of 2017.

Do you see a rate cut in 1Q17?

A rate cut was expected in December 2016, but RBI surprised with a no-move decision. While the guidance was accommodative, the policy committee preferred to wait for more clarity on the impact of demonetisation.

This was reflected in a conservative downward revision to RBI’s GDP estimates, while upside risks to inflation were flagged from sticky core inflation, firm non-perishable food items, upturn in oil prices and currency volatility. Back then, a stand-pat was also prudent in light of lingering uncertainties, especially ahead of the then US Federal Open Market Committee (FOMC) meeting.

Given the likelihood of slower growth and the risk that inflation undershoots the RBI target path, the door remains open for a 25 basis points rate cut in the first half of 2017.

Investments in big projects and company loans were subdued in 2016. How much of a recovery do you see in 2017?

An RBI survey on listed private sector companies offered a glimmer of hope as aggregate sales growth rose 1.9% in the September quarter after near stagnation in the quarter before. Operating profits, however, contracted on rising raw material expenses. Service sector industries were still in a tough patch on sales and profitability.

At a more aggregate level, stalled investment projects as a percentage of total under implementation are up from 9.7% in late 2014 to 11.8% in December 2016, according to the CMIE (Centre for Monitoring Indian Economy). Of these, the incidence of private sector projects is higher than the public sector commitments, with reasons ranging from lack of clearances, land acquisition problems or inadequate raw material supplies, among others. These trends are also reinforced by the moderation in loan growth to the industry, which slipped into negative in late 2016. Capital formation growth under GDP has contracted for three consecutive quarters to September 2016.

Weak earnings have limited corporate ability to deleverage and hurt their debt-servicing capability. Recovery this year might also be hamstrung by the recent demonetisation drive and higher commodity prices that might lift input costs and hurt their bottom line. Much of the official efforts are likely to be directed in this effort this year as well; albeit a swift turnaround this year might prove to be a challenge. Until then, public sector investments will continue to pick up the slack.

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