India’s shock therapy has serious side effects | Sunday Observer

India’s shock therapy has serious side effects

Sep 15: Over the past year the government of Prime Minister Narendra Modi has administered two rounds of shock therapy to India’s $2 trillion economy. In November it banned high-denomination currency notes as a way to combat the country’s notorious corruption and tax evasion—and the vast shadow economy the two vices sustain. This summer, Modi’s government rolled out the biggest tax system overhaul since India’s independence, promising it would lower costs for companies.

While both moves may pay off in the long run, their toll on the economy has been higher than initially anticipated. Data released on Aug. 31 show that growth slowed to a rate of 5.7 percent in the three months ended June 30, from 7.9 percent a year earlier, the weakest pace since 2014, when Modi came into power pledging to spark faster growth with a package of business-friendly policies dubbed Modinomics.

Biggest outflow

In response, Morgan Stanley, UBS Group AG, and other investment banks have pared their forecasts for the 2018 fiscal year, which ends on March 31. Foreign investors pulled $1.7 billion out of Indian stocks in August, the biggest outflow in 2017, underscoring the change in sentiment.

The idea behind demonetization was straightforward: Forcing people to swap their currency notes for new bills would unearth hidden wealth from individuals and businesses that weren’t paying taxes. But since cash is king in India, a plan that called for removing 86 percent of all legal tender created tremendous disruption. The policy was implemented in a rush: The announcement came on Nov. 8, giving Indians just four hours before their cash became worthless. Moreover, the government had not ensured a large enough supply of the new notes, which set off a scramble.

Former U.S. Secretary of the Treasury Lawrence Summers was one of the many prominent economists who criticized demonetization. Manmohan Singh, who served as India’s prime minister from 2004 to 2014, reckoned it could strip as much as 2 percentage points off economic growth.

One of the industries hardest hit has been construction. The sector is the country’s biggest job generator and also a haven for black money, which is what Indians call funds that have been secreted away from the prying eyes of tax collectors. “The intention for the cash ban was fine, but the way Modi applied it was wrong,” says Rakesh Jain, who owns Shree Paras Steel Fab Pvt Ltd., a supplier of steel products to builders. “They should have printed the new notes and then canceled the old ones.” The company is based in Uttar Pradesh, India’s most populous state and a center of the informal economy. “There are no new projects, and those that were on the ground have slowed,” says Jain, who reports that annual revenue has fallen at least 33 percent, to 400 million rupees ($6.3 million), since the policy took effect and that he’s been forced to dismiss 4 of his 12 employees.

Levies replaced

In another bid to take in more tax revenue, Modi’s government on July 1 replaced an assortment of state and federal levies with a nationwide Goods and Services Tax (GST), which is designed to be more difficult to dodge. Along with helping the government lower its budget deficit, the money could help pay for improvements in public infrastructure, such as roads and schools, boosting India’s economic competitiveness. The adjustment has been difficult, however, particularly for small businesses.

“In the short term there may be some glitches,” says Ministry of Finance spokesman D.S. Malik. “But in the long term, policies like demonetization and GST have and will make the economy more transparent. We’re moving towards a more formal, digitized economy, and the tax base is being widened.”

The pace of growth in private consumption, which had been driving the economy, fell to 6.7 percent in the April-June period, from 8.4 percent a year earlier, while investment has stalled. “There’s been a slowdown. We definitely feel that,” says Sanjay Bhatia, managing director of Hindustan Tin Works Ltd., which supplies packaging to such companies as Nestlé India Ltd. and Asian Paints Ltd. The cash ban drove sales down about 4 percent from January to March, he says, though “things are getting back to normal.”

Deeper problems?

The question is whether the April-June slowdown is a blip or a warning sign of deeper problems. Kaushik Das, an economist at Deutsche Bank AG, trimmed his growth projection for the current fiscal year, to 7 percent from 7.5 percent, but says demonetization and GST are temporary disruptions and that the effects will start to dissipate this quarter.

Domestic investors haven’t lost faith in Modi’s ability to stoke growth. India’s benchmark stock index is up about 20 percent this year, making it one of the world’s best performers, buoyed by record local inflows into stock mutual funds.

Judging from the ruling party’s landslide victory in state elections in March, ordinary Indians are also standing with their prime minister. About 8 in 10 people said the state of the economy is good, according to a Pew Research Center survey released in June.

And 30 percent called it “very good,” the highest among the 32 countries included in the survey.

Such sentiment, coupled with a weak opposition Indian National Congress party, bodes well for Modi, who will face national elections by 2019. An early September cabinet reshuffle that freed up Finance Minister Arun Jaitley to focus solely on the economy will help further convince the electorate that Modi’s working to reverse the growth slump, according to Sandeep Shastri, a political scientist and pro vice chancellor at Jain University in Bengaluru. “People are looking at the sincerity of the effort,” Shastri says. “The way the government goes about doing its task is as important as whether they actually achieve it.”

Kaushik Basu, an economics professor at Cornell University, who was previously the World Bank’s chief economist and a top adviser to the Indian government, believes Modi’s administration should go one step further and acknowledge that it bungled demonetization.

“Admitting this as a mistake would make big businesses, foreign investors feel a bit reassured that India is taking a good professional look at it, and it’s not going to make a mistake of this kind again.”

Foreign investors pulled $1.7 billion out of Indian equities in August, but polls show Indian voters have not lost faith in the government’s ability to steer the economy. - Bloomberg.com 

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