8/11 and after: The going won't be easy for some more time

The bigger worry is that its effects could linger well into the next financial year.
Ishan Bakshi reports.
Illustration: Dominic Xavier/Rediff.com

The demonetisation of the Rs 500 and Rs 1,000 notes has been the most disruptive policy measure in several decades.

When Prime Minister Narendra Modi announced that notes of Rs 500 and Rs 1,000 denomination would lose their status as legal tender on November 8, he did not have the comfort of an economy in the pink of health.

The Gross Domestic Product (GDP) grew 7.3% in the July-September 2016 quarter. But, beyond the headline number, growth was on a weak footing.

Gross Fixed Capital Formation had contracted for three straight quarters, with the pace of contraction actually accelerating.

The capital goods segment in the index of industrial production (IIP), which connotes investment demand, had been contracting for more than a year.

Similarly, export growth was lacklustre. After growing at 9.6% in October, growth plummeted to a mere 2.3% in November.

Government spending is also likely to be curtailed as disinvestment receipts have been below the budgeted amount and spectrum auctions didn't yield the expected bonanza.

Given this scenario, all eyes were on a recovery led by consumption.

A confluence of factors, working in tandem, were expected to prop up household demand beginning from the third quarter.

First, after two back-to-back droughts, a good monsoon was expected to shore up rural incomes, propping up rural demand.

Second, urban consumption was expected to get a fillip on account of proceeds from the Seventh Pay Commission.

The resultant increase in demand was expected to boost industry's capacity utilisation rates, triggering off fresh investments.

A virtuous cycle would ensue. Or so it was hoped.

Instead, the government's decision to scrap roughly 86% of the currency in circulation has ended up dealing a severe blow to the hopes of a consumption-led recovery.

If anything, growth prospects are now bleaker.

While it is difficult to accurately gauge the impact of this measure on growth, aggregate demand is expected to fall in the third and fourth quarters.

The bigger worry is that its effects could linger well into the next financial year.

Economists expect the decline in demand to compel firms to cut back production as inventory piles up. This will delay new investments.

Firms were operating only at 72% of their capacity, according to data from the Reserve Bank of India capacity utilisation survey in the April-June quarter. This is likely to decline further.

"Small-and medium-scale enterprises are likely to face a prolonged period of distress," says Madan Sabnavis, chief economist at CARE.

Former Chief Statistician of India Pronab Sen concurs. "Small firms will suffer. Larger units are also under stress," he says.

Add to that, rise in the raw material prices and firms are likely to face severe margin compression.

According to a report from Kotak Institutional Equities, prices of 65% of the 40 basic raw materials they track are increasing. In some cases, the increase is in double digits. 'The risks to margins are being underappreciated,' it says.

As companies cut back production, demand for working capital loans is likely to fall, affecting bank revenues.

"The banking sector is in a bad shape. While bank liabilities have increased, only a part has been parked in the Market Stabilisation Scheme bonds. They still have to pay interest on the rest. But credit has collapsed," says Sen.

The real worry now is the efficacy of policy levers to offset the impact of demonetisation.

Monetary policy is one possible lever.

While the Monetary Policy Committee erred on the side of caution in its December 7 meeting, analysts expect it to cut rates in February after the Union Budget.

But the ability of a rate cut to prop up demand in the short term is debatable.

"Interest rates are only a facilitator. I don't see demand for credit picking up until consumption demand picks up," says Sabnavis.

Sen is even more circumspect about the efficacy of monetary policy in the current scenario.

"Monetary policy is bust. The normal levers through which it operates changes in base money. But now you don't have enough base money," he says.

That leaves fiscal policy as the only game in town.

The question: Does the government have enough fiscal room?

Even if one assumes that the FRBM Committee does indeed provide the government with the space to boost spending, will it be enough?

"Fiscal policy also has its limits. Increase in spending may not be large enough to turn things around," says Sabnavis.

A possible way to shore up demand is to transfer the bounty from demonetisation, if there is one, to the poor.

"While fiscal policy has its limitations, it could provide an immediate boost if there is a transfer to Jan Dhan accounts," says Sen.

"MNREGA is absolutely critical," Sen adds, "but it will work only if the central government gives assurances to state governments that funds will be disbursed."

Tinkering with tax rates to increase disposable income is another possibility.

But, it is difficult to predict its impact on boosting consumption in the short term, as people may simply use the extra room to shore up their precautionary savings.

The going won't be easy for some more time.