Demonetisation: The worst may still be ahead

Demonetisation: The worst may still be ahead

Submitted by alvin on Thu, 2016-11-17 11:11 The demonetisation of Rs500 and Rs1,000 on Nov 8, a few hours before midnight, was the mother of all surgical strikes! It reminded one of Pandit Nehru’s famous statement on the eve of Indian Independence, “At the stroke of midnight, when the world sleeps, India awakes …” Of course that was to the joy of Independence. On Nov 8, it was to the fear of 85�f our currency being frozen by midnight. Since then, there has been chaos at banks, public utilities and other areas where one can change Rs500 and Rs1,000 notes. However, this is a minor inconvenience to what might come next. It is a temporary problem which the government will solve one way or the other. The primary objective of demonetisation was to remove black money from the economy. How successful the move will be is a question for the pundits of the future.  What we know today is that black money at around $1 trillion constitutes over 50�f the Indian economy which is estimated at $2.1 trillion. Most people would agree that it is a menace that should be exterminated. However, demonetisation is only a superficial way of doing it, but since it has been done the million dollar question is - what next? I see a lot of statements in the press of how this will benefit India in the short and medium term, and I agree that this could, and I qualify again, ‘could’ be true. The medium and long-term in economics when it comes to countries is a 2-10 year period. The world is so volatile today, that to say with certainty what will happen in the mid to long term is a prediction that will put Nostradamus to shame. The best example of what we think will happen is to take our cue from a truly great leader, Mahatma Gandhi, who said, “The future depends on what we do in the present.”  And that is our answer. We have to look at what is happening at present.  If India wants to predict what could happen in the medium term to our economy, we have to look at the ‘Mercedes star’. This is a 3-pointed star enclosed in a circle. The three points relevant to us today are India, the United States, and the rest of the world. In today’s connected world, no one can exist in isolation. We have to factor in what is happening in the other points of the ‘star’ to understand how we will also fare. Let us start with India.   The effect on the Indian economy The Indian economy is not doing as well as is being portrayed. Although growth rate is good, certain indicators are not good at all. The Index of Industrial Production (IIP), which shows how much our industries have grown, is at 0.2�verage growth from January to September 2016. Capital goods output, which is an indication of investment in the manufacturing sector, has been contracting since 2015. While at first glance this is not too worrying as manufacturing contributes only 24�o our GDP, it is not so good when you consider that it contributes over 60�f our exports. And 4 sectors - petroleum products, precious stones, automobiles and machinery account for 42�f our exports. This is bad news as these are not high growth industries. Petroleum products is seeing a decline, and so will precious stones and automobiles if consumption worldwide falls, which, according to present indications, is likely to do so.  The golden goose of the Indian economy is the services sector, which constitutes 57�f India’s GDP and is the 2nd fastest growing sector in the world after China. And it is growing by leaps and bounds. Unlike traditional manufacturing businesses which need large investments, services can make do with fewer investments, quicker cash flows, and greater liquidity. Services include finance, real estate, insurance, communications, public services, software, hotels, restaurants, and others. In 2000, services contributed 12�o exports. In 2016, the figure stood at 23� almost double. India’s future does not depend on ‘Make in India’, but on ‘Services from India’. The largest sectors in the service industry are financial services and real estate at 21�restaurants at 12.5�nd software at 7.5�By sucking out the liquidity from the Indian economy (though it was black money, it was used in consumption in these service industries among others), demonetisation will contract them badly. We can see a huge contraction in the service industry as people will dramatically reduce spending. For those who don’t have black money, (and this is a majority of the population), this will be due to fear of this happening again. Those having black money will convert it into foreign exchange, or move it abroad. Either way, it will be a huge contraction of consumption of goods and services. Indians are generally not flamboyant spenders. According to the World Bank, Indian household consumption is already 20�ess than the developed world. And if you need your economy to grow, you need to either fuel your economy by spending or by exporting.   USA and the world More bad news ahead. The US is the most important point of the ‘Star’. With the election of Donald Trump, we are in for bad times, even if he fulfils a small part of his election promises. One thing for sure is that he will look at a massively reduced corporate tax for American companies. He is talking of reducing it from 35�o 15�and the Republican dominated Congress will agree as they want the same. This will result in contracting of American capital and business to the rest of the world, so they can take advantages of these benefits. Places like Singapore with a 15�ax rate will not suffer. But India? Definitely. Outsourcing to India will be in trouble, as the difference in tax rates along with a lot of tax benefits he is offering will ensure a reverse flow of business and capital. This will badly impact our software sector which is 7.5�f the GDP, as well as the BPO industries and a lot of other services industries. India cannot look to the rest of the world for help. The Middle East is in very bad shape due to low oil prices and high consumption habits. Trump is threatening to abandon the region to the Russians and increase USA shale oil production, making their situation worse. India will gain from oil prices being low, but that is not enough to offset our problems on liquidity. The Asian countries are facing badly slowing growth, and if Trump starts a trade war with China, as he has threatened to put a 45�ax on Chinese goods, they will go down even further.   India alone So what does the future bore for India in the next 12 months? The best case scenario is deflation. The worst - recession. Sceptics would point to the thousands of crores banks are getting in deposits. But this is a problem not a solution. When the market had liquidity, the SME’s who contribute 45�o manufacturing output and 40�o exports never received benefits from the banking industry. The procedures are so cumbersome that most SMEs to improve their cash flow go for loans to informal credit agencies, or factored their loans (selling to third parties at a loss for immediate money). This will all be gone with the liquidity crunch. The government may spend thousands of crores in infrastructure and on their pet social schemes. But this will not improve the economy apart from some superficial improvements, as the major drivers of economic growth - the SME’s, service industries and manufacturing are all heading into a downward spiral.