Lurking challenges before the economy

The growth rate of the economy has declined to 6.1 per cent in the fourth quarter ending March 2017, compared with 7.1 per cent in the previous quarter. The growth rate of Gross Domestic Product or GDP has declined to 7.1 per cent in the full year 2016-17, compared with 8 per cent recorded in the previous year.

This decline is being attributed to the dislocation brought about by demonetisation. That is not entirely correct. The growth rates were 7.9 per cent, 7.5 per cent, 7.0 per cent and 6.1 per cent in the four quarters of the last year. Thus, the decline has set in well before demonetisation. We need to look both at demonetisation and beyond to understand the causes of the decline in the growth rates.

Demonetisation was part of the drive towards a digital economy aimed at cleaning up black money. The government found itself on the back foot during demonetisation because the bank officials collaborated with black money holders and provided them with new notes against old.

A similar fate may be awaiting the government’s efforts to collect punitive taxes from those who have deposited huge amounts of cash in their accounts. The government has apparently sent notices to lakhs of bank account holders to explain the source of the cash deposited with them.

These notices can play out positively if tax officials do not ask for bribes from the honest and recover taxes from the dishonest. The same notices will play out negatively if tax officials collect bribes from the honest and let off the dishonest. In this case the harassment of the honest will push the businessmen to clam up.

Their energies will be directed in thinking out ways of meeting the bribes demanded by the Income Tax Officers. They will not be thinking of making new investments or expanding their business. The present cadre of Income Tax Officers (ITOs) does not inspire confidence because the menace of black money would not have arisen had they been honest.

The government is relying on the same corrupt officials to clean up the system who are the root cause of the rot. It is like appointing the thief to man the police station. The way forward is to establish an independent proactive spy system to watch on the ITOs and an appellate system to provide quick and effective relief to the honest.

The consumer too has gone into a shell due to demonetisation. Womenfolk had some cash stashed away as security. That cash has been forcibly placed in the banking system leaving the women with no savings to fall back on. They want to rebuild the hoard for their security.

There is also a fear that the government may again demonetise notes of Rs 2,000 or even those of Rs 100. Hence there is reluctance among women to rebuild their hoard in cash. They now prefer to hold gold. Reports indicate that gold imports in April 2017 were more than double from a year ago.

This is leading to outflow of the nation’s wealth to foreign countries like Russia that produce and export gold. It is better for the economy that people hold the money in cash because then the money stays in the country. The government must accept that demonetisation has been a failure and assure the people that there will be no further demonetisation so that this penchant for buying gold and the consequent outflow of our wealth can be contained.

Now let us look beyond demonetisation. The Government is on track towards controlling the fiscal deficit to the targeted 3.5 per cent of the GDP. This is a great achievement. The underlying belief is that control of fiscal deficit will be seen by foreign investors as the government being responsible and the economy being stable.

They will come in droves to invest in India. This belief is predicated on the assumption that multinational corporations are keen to invest. There is a pent up demand of goods in their home markets. For example, General Motors will establish a car production unit in India if the demand for its cars in the United States is buoyant.

The present scenario is quite unlike this. There is growing pressure in the developed countries for their companies to come back home as indicated in Brexit and the repeated calls made by Donald Trump to the American multinationals to produce in the United States.

It is unlikely therefore, that control of fiscal deficit will translate into true inflows of big ticket foreign investments. The high flows noticed until recently may be more in the nature of round-tripping to take benefit of the window that was open until March 2017 in the renegotiated Double Tax Avoidance Agreement with Mauritius and other countries.

The control of fiscal deficit will, however, certainly lead to contraction of government investments. Thus, it will push the economy deeper into a slowdown just as the policy of balanced budget had pushed the American economy into the Great Depression in the 1930s.

It is not possible for the government to increase fiscal deficit and use the money to make investments because that will lead to increased demand for steel and cement in the country and push up inflation leading to a political backlash.

The way out is to increase fiscal deficit but use the money to import steel for public investment. That will lead to a decline in the value of the rupee but prevent domestic inflation. Such a policy will not disturb the domestic markets and also jumpstart the economy by increasing investments.

The future of our exports of goods and services is at stake in view of the increase in protectionism in the developed countries. Trump has proposed to reduce the numbers of H1B visas that are used by Indian engineers to supply manpower to American companies.

He has also proposed to impose an additional tax on goods imported into the United States from Mexico. We may expect this approach to overflow into higher taxation of all imports into the United States including those from India. Knowledgeable sources suggest that the United States may soon impose restrictions or increase taxes on imports of drugs from India.

This march towards protectionism will hit at our exports. Imports however will increase because our government is committed to the policy of free trade. Imports from China will increase. This will kill Indian manufacturing as has happened in the last few years. The way out is to embrace protectionism.

Expecting that Trump will impose higher taxes on goods imported from India, we must proactively impose higher taxes on goods imported into India not only from the United States but also all other countries, including China. That will provide an incentive to Indian businessmen to invest and it will jumpstart growth in the country.

By Dr Bharat Jhunjhunwala