GDP: Expect bigger shock from note ban; PM Modi needs an exigency plan

For Prime Minister Narendra Modi, a pro-growth political leader from his early Gujarat days, the July-September GDP data wouldn’t have come as an encouraging set of numbers. It is indeed disappointing, despite a marginal improvement in the overall numbers to 7.3 percent in Q2 from 7.1 percent in the April-June quarter. Reason: the only bright spot in the GDP graph is a minor improvement in the agriculture sector. Investments are doing bad, manufacturing and industry revival isn’t seen so far.



But, for PM, the bigger disappointment is probably yet to come. That will happen when the likely impact of the ongoing demonetisation exercise, which has considerably reduced the chunk of cash in people’s wallets, harm the consumption story in the next few months or even more. This will reflect in the macroeconomic numbers in the second half of this financial year.

There is a compelling reason for PM Modi and his economy managers to worry when that happens. Why? Because, consumption has been the only major saving grace for an economy of 1.3 billion people, for quite some time. This is particularly so since, as mentioned above, an investment-led recovery still remains a dream and industrial revival isn’t happening at the desired pace. Now, that’s a huge challenge for the government, aspiring to take the economy to the next orbit of growth. To understand this problem in detail, let’s look at the numbers.

Gross Fixed Capital Formation (GFCF), which portrays the actual investment activity on the ground, dropped by close to 6 percent at constant prices. Now remember, this parameter has been contracting for the last three quarters at least. Not a healthy sign for an aspiring, ambitious economy. When investments don’t support a growth-revival, typically, a consumption-led recovery should come to the rescue.

Now, what has been happening here is the government spending, which picked up from the last quarter in a major way, has actually dropped in the second quarter, from 18.8 percent in Q1 to 15.2 percent in the Q2, in terms of constant prices. As against this, private spending has shown a marginal increase during the period — from 6.7 percent in Q1 to 7.6 percent in Q2.

In terms of current prices, the government expenditure has fallen to 20.8 percent on year-basis in Q2 from 24.3 percent in Q1. The corresponding numbers for private spending is 11.7 percent in Q1 to 12.4 percent in the Q2, showing a minor rise. If one looks at sectors, except the growth shown in agriculture, all other segments —mining, manufacturing, electricity, construction and services such as hotel industry— all have shown a decline.

In short, these numbers tell us that it is consumption that is holding the growth story and remains as the main driver. But, this is where the challenge lies ahead in the aftermath of the demonetisation exercise. Though there may be long-term benefits in the form of more tax income, more compliance, push to cashless modes, most economists agree the near-term negative impact on the economy this exercise will cause. This is because the note ban move has taken away the spending ability of a significant number of the general public, almost overnight, by choking the cash flows in the system.

This would mean people have less cash to spend in hotels, textile stores, holidays, cinemas and other purchases, which they would have done in the normal course of life. But, till the time withdrawal limits stay in the banking system, bank branches/ ATMs are replenished with enough cash to cater to the public demand. Even those who managed to get Rs 2,000 or Rs 5,000 from their bank would hesitate to spend the money except for real necessities, or in other words turn hoarders of cash. This, in turn, slows down the circulation of the money in the system and creates a stalemate.

This will negate the positive factors such as the 7th pay commission and OROP payments, which should have aided the consumption story. Even one needs to wait and watch how the agriculture sector does post the demonetisation era, since farmers too will face difficulties to get cash, especially during the approaching Rabi season. This is an irony because this is a year when farmers got good rains after two consecutive years of drought. Then there is a cash crunch. Already, there are reports that Rabi sowing has been slower than normal this year. According to an Edelweiss report, about 50 percent of the Rabi sowing season is complete and as per the data until 25 November, 2016, the sowing activity has been slower than normal.

While it is up 4.5 percent YoY (partly because sowing last year was impacted by low reservoir levels), it is down by 7.5% compared to normal sowing. In fact, it has deteriorated from the previous week (week ending 18 November) when sowing was running 4.5 percent below normal. Among crops, sowing of pulses has been very good (up 7 percent versus normal), oilseeds has been about average, while wheat has been a big laggard (down 15 percent versus normal).

“Overall, the slower pace could perhaps be the result of demonetisation. As of now, cash withdrawals continue to lag the pace of deposits. As per latest data, total new currency available with the public is now Rs 2.5 lakh crore as against the demonetised value of Rs 15 lakh crore. Given the current pace of cash withdrawals it appears that the cash crunch could persist till at least end of January 2017,” the Edelweiss report said.

The point of highlighting what the numbers tell is not to portray a doomsday scenario, but the fact is that there is pain on the way post demonetisation days.

What are the options before the government at this stage to support growth? First, it must use its good offices to prepare a contingency plan to ease the cash crunch. The printing of lower denomination notes needs to be more aggressive since ample supply of these units (Rs 500 and below denominations) could ease the cash shortage in the system.

If the capacity of the government presses isn’t adequate, the government should also print money abroad. As the next step, it should stop imposing limits for normal withdrawals, since restrictions contribute to even more panic-driven cash demand. The sooner the government resolves the puzzle of Rs 500 notes, the faster will be the recovery from the current situation. It can even think of tapping big money chests such as those in temples like Tirupati, where there is a huge treasury of currency notes accumulated over the years. If the government can tap these notes, these can be channeled to the public circulation.

Second, there is a case to ramp up public consumption even higher to offer a support to the sagging economy. This is even more important since private consumption is likely to take a step back in the approaching quarters. The numbers tell us that the government’s recent focus on spending has declined in the second quarter. Putting more money into infrastructure projects and other areas would again help to revive the consumption cycle. The other critical part is not to lose focus on reforms such as the crucial Goods and Services Tax (GST) getting lost in the demonetisation mess.

If the GST is delayed further, that will yet again send a wrong signal to the investor community that the government has deviated from its pro-reform path. The fate of April, 2017 GST deadline looks uncertain now, given the oppositions' protests on demonetisation. The government must find a way around to get the game going. Third, make sure the agriculture sector would not suffer because of the cash crunch.

To be sure, the government has already taken some steps such as allowing state-run distribution centres to accept old currency notes for agri-input purchases. But, more caution is warranted since lower farm output means high inflation ahead. The full fiscal GDP growth is likely to end below the 7 percent mark on account of the demonetisation implementation. But, even a 6.5 percent growth is good enough for India as long as the short-term pain of the reform measures results in long-term gain (higher tax collection, more money for productive use etc).

It is time for PM Modi himself to take the lead to minimise the damage caused by one of the boldest reform measures initiated by him, the intention of which isn’t doubted even by his political opponents. But, it is critical to make sure that the situation doesn't go out of control. The 7.3 percent GDP figure and the dim forecast ahead offers a good reason for the PM to take a relook at his plan for the economy.

Data support from Kishor Kadam

Updated Date: Dec 01, 2016 12:59 PM

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