In 2016, the monsoon was good, and the Seventh Pay Commission enabled urban consumption demand. Thus, it seemed that FY17 would clock 7.6-8% growth. But just when India’s economic growth started on a long-term trajectory, demonetisation suppressed it, and 7.6-8% growth is now unattainable. The latest IMF projection of India’s growth rate for FY17 is 6.6%.
Overall economic activity
Demonetisation negatively affected sectors such as services, real estate and allied sectors, construction, consumer durables, automobiles, FMCG, and the informal sector. The services sector contributes more than 65% to India’s GDP. The Nikkei/Markit Purchase Managers’ Index (PMI) dropped from 54.5 in October to 46.8 in December post-demonetisation. This fall below the threshold level of 50 implies a contraction. Similarly, the manufacturing PMI dropped to 52.3 in November from October’s 54.4—its biggest month-on-month decline since March 2013—while the Nikkei India Composite PMI Output Index recorded 47.6 in December, from 49.1 in November, again a 38-month low. Interestingly, the IIP showed a growth of 5.7% in November 2016 despite the note ban effect, but it can be argued that this lift could have arisen on the back of a weak base in November 2015 that had a 3.4% contraction.
Consumption is a major expenditure that contributes to GDP. The demonetisation drive has suppressed private consumption demand, and households have postponed their purchasing of consumer durables. Sectors like consumer durables, FMCG and retail (except organised retail) have been severely affected and should report significant fall in revenues in the future. The sales of FMCG companies had gone down by R3,840 crore in November as compared to October. The automobile sector witnessed its biggest drop of 18.66% in sales in 16 years in December, especially in two-wheelers, where over 60% of sales are in cash. Employment has also seen a significant decline in these sectors in the past two months. While this may persist for another two quarters on the back of low and cautious consumer spending, it is expected to gain momentum from the second quarter of FY18.
Demonetisation severely affected real estate, which was already battling a prolonged demand slowdown. Since then, it has seen a 25% reduction in sales, especially in tier-2 and tier-3 cities. According to brokers and analysts, sales in major cities like Delhi, Mumbai and Bangalore have seen a major dip as consumers are taking a ‘watch and wait’ approach amidst the speculation on further measures for benami properties. Hence, we could expect another weak quarter for the real estate sector.
Informal sector, employment
The informal sector, which accounts for more than 45% of the GDP and 80% of employment, has been severely hit by demonetisation, as daily wage labourers find it difficult to secure employment. For instance, the textile sector—which employs nearly 70 lakh people as daily labourers—was unable to pay them because cash supply was inadequate.
Similarly, industries like leather, handloom and construction were badly hit, with significant wage implications for its casual workforce. In fact, the economy is already experiencing a decline in employment growth during a period of high growth, and it might aggravate in the next few quarters when the actual effect on GDP growth is felt on the ground.
This leads us to ask: How can the Union Budget offset the possible impact of demonetisation?
Now, since all the impacted sectors may not rebound equally, we expect a Budget that incorporates demonetisation-induced changes and adequate fiscal incentives. Hence, the focus should be on offsetting the demand downturn by improving sentiment in the economy and increasing investment rates for higher growth. In addition, the government is expected to announce a special corpus to fund digital payment systems in rural areas.
Taxes and revenues
On the revenue front, the government has gained from the declarations made in the Income Disclosure Scheme-1 (IDS-1) that ended in September 2016. The disclosures, estimated at R60,000 crore, generated R30,000 crore in tax revenues. According to experts, another bout of tax revenue amounting to R1 lakh crore is expected from IDS-2. The gains from IDS-2 will accrue to the next fiscal year and could be used to finance a big portion of the fiscal deficit. The government could use the amount raised through IDS-1 by spending on infrastructure and helping offset the expenditure accruing next year in the form of the Seventh Pay Commission arrears as well as revised structures.
In the long run, demonetisation is expected to increase the tax base and tax revenue as the share of the formal economy increases. As a result, we may expect widening of the tax base, an increase in the tax-to-GDP ratio, reduction in corporate tax, and raising of tax exemption limits. Reduction in personal income taxes and increase in exemption limits will increase liquidity with households and will boost consumption spending, especially the lower income group. However, the government should be careful about tax cuts if it can increase the base, as tax revenues have been quite stagnant in the past couple of years, and explore other avenues like disinvestment, market borrowing, etc. This will increase production capacity and employment and, concurrently, improve private investment in insurance and mutual funds.
To offset this reduction in tax revenue, the tax base should be widened. On the other hand, reduced corporate tax will increase revenues and net profits for firms, which will positively impact investment and facilitate higher economic growth and job creation.
The external sector has been showing signs of fragility and weakness—exports have been falling for the last 24 months and the recent Fed hike, coupled with Donald Trump’s victory in the US Presidential elections, has fuelled outflows of FIIs. The export industry can be revived through the upcoming Budget if the finance minister provides sufficient financial stimulus to boost the sector. For instance, a scheme for providing subsidised credit to exporters, which will expire on March 31, 2017, can be extended. As suggested by the Federation of Indian Export Organisations, a special export development fund can be used to help small exporters.
In addition, the government should try to administer an effective oil price-through mechanism to mitigate the effects of higher oil prices, and should provide incentives for the renewable energy sector, especially domestic manufacturers of solar panels, to reduce dependence on imports.
In summary, while the government will have enough buffer to provide the necessary fiscal stimulus to revive the economy, it is expected that it will be more pragmatic in its approach to concomitantly fulfil the long-term objective of fiscal consolidation.
Pravakar Sahoo is professor, Institute of Economic Growth, Delhi University. Bhavesh Garg is researcher, Indian Institute of Technology, Hyderabad