Stimulus is inevitable but will be less effective

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The hastening up of the central government to suddenly flesh out a fiscal stimulus, contrast to its recent hubris claiming India being the fastest growing economy in the world. This is especially so because of its oft-repeated proclamation that its magnum opus moves of demonetization and GST implementation are case studies for the world.

Clearly, the reality is beginning to bite with Q1FY18 real GDP growth floundering to a 4-year low of 5.7%. While there were always doubts about the strength of the strong 7-8% GDP growth estimates earlier given their discordance with several high-frequency industry level indicators, events such as demonetization shock and dislocations caused by the hasty GST implementation have delivered a body blow to the frail economy.

Blunting the official arrogance, the unfolding of the wider debilitating impulses of demonetization on the informal sector, agriculture, banking sector, RBI’s financial health and job losses is clearly building up a case for a strong fiscal stimulus as a last-ditch attempt to shore up the economy.

But, this is hardly surprising. In Nov. 2016, our prognosis was that demonetization shock will shave off 270bp from real GDP growth, as it will have a meaningful impact on demand, corporate performance and the labor market, besides the ripple effect on various variables. We were of the view that the overall impact of demonetization can be a prolonged one and will trigger redoubling of fiscal stimulus to resurrect growth. It was also expected to create challenges for the RBI beyond just printing notes [Demonetization shock to impel fiscal stimulus, Nov 30, 2016].

So, what has demonetization attained? Looking beyond the avowed objectives of curbing black money, excess dividend from RBI, digitization, extinguishing fake currency etc, for which the evidence of success is precious little, the damage has been far greater.

First, the jolt to the farm sector terms of trade (ratio of price realization from sold output vs cost of cultivation), especially in perishable items, has snowballed into an avalanche of farm loan waivers. The fiscal burden for state governments has been significant. We estimated that at 18-20% write-off of institutional lending at an all-India level will imply a mammoth Rs3.0-3.5tn; not far from recent estimate of Arvind Subramanian at Rs2.2-2.7tn. [There is a bigger message in farm loan waivers, unrest in hinterland, Jul 1, 2017] 

Second, the overall cost on RBI for executing the demonetization could be Rs400-500bn in the form of loss of earnings, cost of printing new notes and logistic cost etc.

Third, NPA ratio of the banking sector, particularly the PSU banks, has expanded. GNPAs for large PSU banks rose to a high of 12.3% in Q1FY18. While the temporary decline in G-Sec yield has led to a fortuitous windfall in the form of trading gains, their core earnings and margins have eroded further.

Fourth, job losses have been intense in the informal, real estate and SME sectors (which contribute significantly to India’s exports). This is reflected in higher allocation for MNREGA, which absorbs the residual unemployment in the informal sector. Even in the formal sectors, surveys during earlier quarters of 2017 have indicated significant job losses (source: FICCI, CMIE surveys) due to various factors (including fall in orders and economic uncertainties). Exports growth has decelerated sharply and has contracted recently. A recent report by Teamlease confirms weak employment scenario for H1FY18 and 30-40% decline in jobs in the manufacturing sector.

The aforementioned issues are among the few symptoms of a faltering economy. The hasty implementation of GST has only compounded the problems that has only added to the demonetization-led disruptions. Data released by RBI indicates that notwithstanding its effort to print new notes overtime, the re-monetization process remains incomplete even after 10 months of the demonetization announcement.

While the GST implementation has been facing various glitches, misinterpretations, IT snags etc, the net effect on indirect tax collection is still obfuscating. Reports indicate that the initial robust claims of Rs900bn collections attributable to GST implementation (Jul-Aug’17) have mellowed due to large scale input credit refunds. Overall, there are several reports indicating considerable logjams in the production process across sectors, especially employment-intensive informal sectors.

It’s no surprise that the urgency is setting in with the Finance Minister Arun Jaitley reassuring the world that there is no crisis situation and that the government is contemplating a stimulus package, including another attempt to resurrect the ailing PUS banks.

But, how much is the fiscal space and what will be the effectiveness of stimulus at this juncture?

Since FY14, India has adopted an image of fiscal rectitude. However, notwithstanding the sharp decline in global crude oil prices from an average of US$110/bbl in 2014 to current US$50/bbl, the combined fiscal deficit of states and central government has declined only modestly from 6.7% to 6.5% in FY17. Importantly, the revenue expenditure has remained high, growing in excess of 20% despite the huge 80% increase in excise duty on petroleum products, indicating poor quality of fiscal correction.

Now, considering a lower estimate of farm loan waiver of Rs2.7tn at all-India level and assuming that states take on this debt over a period of 3 years (i.e. Rs900bn each year), the combined fiscal deficit as percentage of GDP could rise by 40-50bps. In addition, if the central government announces a stimulus of say Rs500bn in FY18, the combined fiscal deficit will rise by 80bps. Hence, assuming an estimated structural fiscal deficit of around 6.8% (close to average of past 5 years), the overall fiscal deficit can potentially rise to 7.6% in FY18, a good 120bps higher than 6.5% in FY17 and will remain around 7.2-7.3% in the following two years.

Not only will it lead to risk of a credit rating downgrade (recent China downgrade by S&P is an indication), the potential benefit to growth can be far less compared to the earlier episode of 2008-2009 (in the wake of the global financial crisis). Why will that be the case?

First, the inter-sector channels for transmission of fiscal stimulus (or even monetary stimulus) have been broken due to the demonetization shock and GST dislocations. My estimate back in 2011 was that every 100bps positive shock in real government consumption spending causes an additional 50bps demand impulse over the next 4 quarters. But, recent growth numbers indicate that under the current circumstances, this multiplier impact has got blunted considerably. 

Second, the macro economic backdrop now is much weaker than it was in 2008-2009. Earlier, the banking system was much stronger, corporate profitability & balance sheet positions were robust, household compensation growth was higher and rural economy was in full steam. All these happened when global crude oil prices were averaging much higher at US$100/bbl back then. But, notwithstanding such a favorable backdrop, the impact of fiscal multiplier could not last more than 6-8 quarters.

At this juncture, the economy is fragile; corporate profits have been stagnant over the past 4 years, banking system asset quality has worsened, capitalization is negative for several PSU banks, and structural supports in the form of household savings, remittances from abroad and invisibles exports have waned. Thus, in the changed backdrop now, both the ability and impulse impact of fiscal stimulus is much weaker. Therefore, it will require a larger fiscal stimulus or higher fiscal deficit to create an equivalent level of demand impact.

Third, India’s current account deficit (CAD) has been rising again. GDP data for Q1FY18 indicates that net exports of goods & services rose to a deficit of 3.8% of GDP, which is a 4-year high. Similarly, the balance of payment data shows CAD rising to 2.4%. The steep rise in external account deficit amid rising government spending over the past two years implies relapse of the “twin deficit problem”, which is only going to worsen with the advent of more aggressive fiscal stimulus going ahead.

While the nature of fiscal expansion will determine whether the CAD will worsen further or not, if it leads to capacity creation then the impact on domestic growth can be enduring and non-inflationary. Conversely, if it continues to focus on revenue spending, it will lead to a consumption-led recovery, which will be a short-lived and inflationary. As the government moves towards the 2019 elections, the likelihood of the populism is higher.

Whether the propulsion in consumption demand will eventually lead to a revival in private sector investment cycle is unclear at this point. But, I think it will increasingly be the case where government outlay on capital account will be compromised in favour of revenue spending (as has been the case in UP state budget).

The reassuring thing however is the build-up of forex reserves with the RBI at US$400bn or nearly 11 months of import coverage, and still conducive global and domestic financial market conditions. But, none of these can be taken for granted. Global financial conditions can get volatile in the wake of narrowing global excess liquidity and uncertain geo-political conditions. Domestic markets are close to all-time highs, with lofty valuations and unsupported by corporate earnings growth. Renewed global volatility, sharp weakening in an overvalued INR against the US dollar can tighten domestic liquidity, leading to hardening G-Sec yields and sudden stoppage of mutual fund flows, which have been robust till recent months.

Overall, the fragility of India’s economic conditions was hardly the backdrop for the government to inject futile shocks like demonetization, and it could have definitely planned GST implementation better. Far from being a case study of success, these events have reinforced the dictum that shock treatment to an ailing patient can be devastating, which even an overdoze of stimulants fail to resurrect quickly.

Having said that, it is most likely that we will now have a series of fiscal stimulus over the next few years, which will intensify in the run-up to the 2019 general elections. We hope that the financial markets remain benign, overlooking the domestic imbalances.