Hoping for better days

ENTERING THE NEW YEAR : Certain developments, apart from reducing deposit and lending rates, are making life difficult for banks already saddled with

Economists are reasonably good at explaining what has already happened. But they are bad at forecasting. So, standing at the beginning of 2017, we would mostly focus on some of the major developments in the global and the Indian economy that took place in the last calendar year while taking some risky guesses about the future.

Two biggest developments in the global economy in 2016 were Britain’s exit from the European Union by popular referendum, and the election of Donald Trump as the president of USA – both events contrary to most pollsters’ predictions (economists are not the only bad forecasters!).

Despite dire predictions, the British economy is not yet worse off after the decision. The British pound plummeted but  it stimulated British exports while the fear of  Britain losing the benefits of the European Common Market is inducing some firms (like the Tata Steel) to sell or move part of  their operations to other parts of EU.

Trump’s win has introduced the greatest element of uncertainty in the global policy space. The casual and conflicting messages about economic and geo-political policy directions thrown up by Trump have kept all countries – both traditional allies and adversaries – guessing. But, as things stand now, it seems that domestically he would go for tax cuts for the rich and the business class while spending more on infrastructure. Both would lead to bigger fiscal deficit which, however, is against the typical Republican philosophy.

Fed has recently raised the policy rate by another 0.25% while hinting at further rate hikes in 2017. So, the expansionary fiscal policy of Trump may well be offset to some extent by tighter monetary policy. If, on balance, the US economy continues to expand (in fact, US is the only developed economy which is showing solid recovery, unlike EU and Japan), it is good news for the rest of the world.

Higher growth of demand as well as a rising dollar (specially if Fed continues to increase interest rate) would mean more exports by the rest of the world, providing a growth stimulus.

On the other hand, because of the higher interest rate in US and rising dollar, the emerging economies like India and China would suffer the consequences of capital outflows, pushing down the value of their currencies, fuelling imported inflation. All these at a time when global crude oil prices have doubled over the year (from $27 in February 2016 to $54 a barrel now)  as a result of both Opec (Organisation of Oil Exporting Countries) and non-Opec countries finally able to work out a production curtailing agreement.

This is bad news for oil importing countries like India and good news for diverse oil exporting countries. New Delhi would benefit to the extent some of the Gulf countries’ higher oil revenue creates jobs for expatriate Indians leading to higher remittances back home.

China’s growth rate has officially come down to around 6.5%. Even if the Indian growth rate loses, say 1 percentage point due to the adverse short-term effects of demonetisation, it is likely that India would continue to surpass China as the fastest growing big economy in the world. It is also likely that after a dip for a couple of quarters due to the liquidity crisis created by demonetisation, the postponed demand would get reflected in a higher GDP growth after some six months or so.

Though, after the win of Trump, the  US-led Trans Pacific Partnership (TPP) is dead, it provides China a good opportunity to fill the vacuum in Asia by trying to forge a mega trading bloc which would include China, Japan, South Korea,  the Association of Southeast Asian Nations (Asean) and India while excluding the US. It thus gives China another leeway to erode USA’s leadership in global economic affairs. The mutual benefits of globalisation, though increasingly questioned in the USA and Europe, are not yet lost in the Asian countries.

Low energy prices

Inflation, as measured by the CPI, is currently below 4% in India while the WPI inflation is even lower. This is largely due to the exceptionally low energy prices and good monsoon.

The phase of low energy prices is getting over, though it is highly unlikely to go above $60 per barrel as any price higher than this is going to bring about a flood of shale oil to the market. So, oil price-induced inflation should be limited. However, the introduction of GST (whenever it is launched) may lead to a one-shot rise in prices.
The squeezing of liquidity from the informal into the formal banking system, following demonetisation, has made banks flush with funds on which they have to pay interest while they cannot find enough credit worthy borrowers.

Apart from reducing deposit and lending rates, these developments are making life difficult for banks already saddled with bad debts. The Fed interest rate hike, however, makes the RBI more cautious to reduce rates, as it increases the risk of triggering further capital outflows, falling rupee and rising inflation.

The fear of scrutinising bank transactions, income tax raids and prosecution - following demonetisation - would certainly induce more tax payments under the voluntary schemes and would increase declared income in tax returns.

Also, the introduction of GST would force business people to insist on purchase receipts on inputs in order to claim tax credits on sales. This is apart from the improvement in RBI balance sheet as some old notes may not come back to the system. Whether that would increase RBI profits or go to the government as higher dividends is not clear at this point.

As higher tax revenue is spent on infrastructure and pro-poor programmes, the negative sentiment surrounding the massive demonetisation experiment may yield to more positive ones, specially if some high profile people are successfully prosecuted and tax rates come down for most people. Apart from the medium-term economic gains justifying the immediate hardships, this may well  be a political plus for the Modi government in 2019 Parliament elections.

(The author is a former professor of Economics, IIM-Calcutta)
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