Expecting the demonetisation to cause sustained downturn, the Centre for Monitoring Indian Economy Pvt Ltd (CMIE) says it sees India's real gross domestic product (GDP) slipping to 6% in FY2016-17. The Indian economy is unlikely to achieve a growth of 7% anytime during the coming five years, it said in a note
Says CMIE, "Before the demonetisation shock, the Indian economy was expected to gradually accelerate its real GDP growth rate from 7.5% to over 8% per annum. The immediate impact of demonetisation was a sharp reduction in private final consumption expenditure, a corresponding fall in retail prices of perishable commodities, a substantive dislocation of labour and corresponding losses in wages and a breakdown of supply chains in many parts. Compared to our earlier forecast, this year’s growth estimate has been scaled down 164 basis points following demonetisation."
"However," it says, "we expect the long-term damage to be greater than the damage caused to growth during 2016-17. On an average, growth during the coming five years up to 2020-21 has been scaled down by 187 basis points compared to our earlier forecast for the same period. We now expect this growth trajectory to shift down to about 6% per annum for the next five years. The economy is unlikely to achieve a growth of 7% any time during the coming five years."
Demonetisation would damage recovery prospects, CMIE says, adding, "Demonetisation has further damaged the prevailing bleak investment prospects. Consumer demand has fallen and liquidity is constrained. Entrepreneurs also face a business environment where the government talks of raids and punitive actions. While these intentions could be good, the effect could be increased litigation and depressed demand."
Pointing out towards the huge cash deposits in banks, CMIE says there should be no dearth of funds for investment in such a scenario, but credit growth is very poor. "As more new currency notes are introduced, some of the deposits with banks will reduce as people who cannot get cash today will start withdrawing it successfully when the cash becomes available. Thus, banks will be less flush with funds towards the end of 2017. It is likely that their non-performing assets (NPAs) will rise because of demonetisation. The government has already announced a relaxation of repayment of loans. The flood of cash notwithstanding, banks’ balance sheets are stressed with large NPAs and their ability to lend aggressively still remains constrained. In fact, the banks’ financial position is somewhat messed because of demonetisation."
"...an investment environment that was already plagued with poor demand and low capacity utilisation is now infested with fears of a further depression in demand, prospects of inspections and raids and a somewhat messed up banking system. Investors are likely to wait for demand to be restored, supply chains to be repaired, the spectre of raids to go away and banks to return to normalcy before they display any enthusiasm regarding the creation of new capacities," CMIE added.
According to the economic think-tank, private final consumption expenditure declined because the available cash on hand to transact retail purchases reduced sharply following the removal of 86% of the currency in circulation. The cash to GDP ratio is high at 12% and reportedly over 90% of the transactions in India are cash-based. As a result, the sudden and sharp reduction in currency had an immediate and significant impact on consumption expenditure.
The fall in retail inflation to 3.6% in November and the fall in sales reported by several fast-moving consumer goods (FMCG) companies are early indications of the fall in consumption expenditure.
Says CMIE, "Labour has been dislocated from productive work as they were forced to line up in front of banks to convert their old currency notes into new ones. Given that banks did not have sufficient new currency notes, this led to substantial dislocation of labour and a corresponding loss of wages. The fall in consumer demand combined with fall in availability of cash also led to a fall in the demand for labour. This sets in a vicious cycle of low demand for labour and low consumption expenditure."
"We expect this low demand to persist till three conditions are met. First, liquidity is fully restored, secondly, confidence in liquidity is fully restored and thirdly, consumers are yanked out of their equilibrium at lower levels of consumption of non-essential commodities," it added.
However, it sees none of these conditions to be fulfilled in a hurry. It says, "Estimates of restoration of full liquidity range from mid-January to September 2017. The Rs2,000 currency notes do not provide liquidity like the decommissioned currencies provided and so we believe that liquidity is likely to be restored only towards the early second half of 2017. It would take a little longer to gain confidence that the liquidity is for real. The government or Reserve Bank of India (RBI) have not taken steps to scotch rumours of demonetisation of theRs2,000 currency notes. As a result, the effective liquidity in the markets is much lower than is measured by the issuance of new currency notes. The Rs2,000 note is less liquid than it would be without the rumours regarding its lifespan."
Further, it says a flight from currency in hand to other asset forms because of a fear of potential loss of liquidity through further demonetisation and a fear of raids or enquiries could structurally reduce the propensity to spend on consumption goods.
"As a result, we expect the hit on consumer spending to last much longer than just a few quarters. Private final consumption expenditure grew 7.5% in 2015-16. This marked a recovery from the much lower growth rates of around 6% in the preceding four years. We had expected private final consumption expenditure (PFCE) growth to accelerate to 7.8% in 2016-17 and then to over 8% going forward. Now, we have scaled back the PFCE growth estimate to 5.5% for 2016-17 and to 6.8% per annum going forward," the note added.
This trend shift in consumption expenditure will delay a revival in investments, CMIE says, adding, "We expect capital formation to shrink by nearly 2% in 2016-17 as against an earlier expectation of a 2.3% increase in the same. We had expected investments to pick up pace each year thereafter to reach 10% growth only in 2020-21. Gross fixed capital formation was expected to remain around 29% and reach 30% of GDP only in 2020-21. Now, we believe that the investments-to-GDP ratio would be only around 27-28%."
"Assuming that private final consumption expenditure does rise at 6-7% per annum, we project that capacity utilisation will rise sufficiently to drive at least some investments. We do not expect any big changes in government or private spending on infrastructure. The push for infrastructure development has been a constant since the mid-1990s. We expect this to continue similarly without any particular acceleration from the trend. We expect government spending to offset part of the impact of demonetisation through increased spending. But, government has a smaller role and can contain the damage only partially," CMIE concluded.