From the GDP data now available, one can estimate that demonetisation reduced GDP growth by about 1.2% in the first half of 2017. This estimate accounts and adjusts for the decelerating trend in quarterly GDP growth since mid-2015-16. This GDP growth deceleration is due to the following factors:
- Monetary policy has not only been tight for the last two years but has tightened further over the last 18 months due to sharply falling inflation. The direct negative effect of rising real interest rates has been strongest on manufacturing and construction.
- Another consequence of high real rates relative to global rates is excessive capital inflows into debt. This results in the appreciation of the real effective exchange rate (Reer) of the rupee, which, in turn, results in loss of competitiveness and the worsening of net exports of manufactured goods.
- Then, there is the return of the economy from deflation to inflation in manufacturing and other internationally tradable goods. The deflation results in leads and lags in input and output prices that result in overestimation of the value added in manufacturing and other goods. The return to normal inflation, however, reverses these effects on inputs and outputs, so that average growth measure values would have prevailed in the absence of a deflation episode.
- Though public sector bank (PSB) non-performing assets (NPAs) were incurred largely during 2009-13, after the global financial crisis, tighter regulations on NPAs and their disclosure to the public were introduced in 2014-16. These forced banks, companies and capital markets to evaluate risks more carefully, worsening credit/investment in 2015 and 2016. So what specific policy changes can help revive growth?
The following reforms should be accelerated:
* GoI must refocus on subsidy reform, and put the savings from reduction in corruption and administrative efficiency into public goods infrastructure investment.
* GoI should expeditiously complete already launched reforms in the bankruptcy law, rules and procedures, and the clean-up of the NPAs in PSBs.
* To get the full benefits of the goods and services tax (GST) and minimise costs, the GST Council must undertake a drastic simplification of the tax to a three-slab system with one base rate, and basic food, health and education as exempt sectors, and 6-12 surcharges.
* Reform the export-import (Exim) policy in agriculture and textiles, and impose a uniform 10% import duty on all manufactures and minerals. Suspend the electronics agreement for 3-5 years if possible, either through export processing zones (EPZs) or free trade zones (FTZs), or other temporary mechanisms for 5-10 years. Provide an opportunity to labour-intensive industries and exit supply chains to shift base from China to India.
* Two consecutive normal monsoons have provided an opportunity to eliminate all export controls and quantitative restrictions (QRs) on agricultural commodities, and reduce export duties to zero immediately. If GoI wants to help farmers on a longer-term basis, it should also repeal the Essential Commodities Act and the Agricultural Produce Market Committee, approve all genetically modified seeds recommended by the Genetic Engineering Appraisal Committee and induce holdout states to join the national e-market for all agricultural products. The remaining impediments to FDI in food retailing of agricultural and related products should also be removed.
* Education is one of the remaining heavily controlled sectors of the Indian economy. The Centre can make a start by replacing controls on higher education with modern, rational regulation, based on asymmetric information and moral hazard problems faced by users.
* Reform of labour and land, the two most distorted markets, have multiple dimensions. Each of them is badly riddled with controls, distortions and corruption. A phased programme of labour and land reform can be drawn up and implemented step by step over the next five years.
The negative effects of demonetisation on GDP are largely over. Because of fears of getting shortchanged on input credit from GST, there was an inventory drawdown in June, and a possible slowdown in production even before that. Both these will be offset in August and Q2 of 2017-18.
On balance, the economy should bottom out in July. But the speed of recovery will depend on reforms and monetary policy.
(The writer is president, Forum for Strategic Initiative)