ECONOMIC OUTLOOK AND POLICY CHALLENGES

• New estimates based on railway passenger traffic data reveal annual work-related migration of about 9 million people, almost double what the 2011 Census suggests.
• India has 7 taxpayers for every 100 voters ranking us 13th amongst 18 of our democratic G-20 peers.
• As of 2011, India’s openness - measured as the ratio of trade in goods and services to GDP has far overtaken China’s, a country famed for using trade as an engine of growth.
• Start first with demonetisation. A radical governance-cum-social engineering measure was enacted on November 8, 2016. The two largest denomination notes, Rs 500 and Rs 1000—together comprising 86 percent of all the cash in circulation—were “demonetised” with immediate effect, ceasing to be legal tender except for a few specified purposes.
• These notes were to be deposited in the banks by December 30, while restrictions were placed on cash withdrawals. In other words, restrictions were placed on the convertibility of domestic money and bank deposits.
• The aim of the action was fourfold: to curb corruption, counterfeiting, the use of high denomination notes for terrorist activities, and especially the accumulation of “black money”, generated by income that has not been declared to the tax authorities. The action followed a series of earlier efforts to curb such illicit activities, including the creation of the Special Investigation Team (SIT) in the 2014 budget, the Black Money.
• Act, 2015; the Benami Transactions Act of 2016; the information exchange agreement with Switzerland, changes in the tax treaties with Mauritius and Cyprus, and the Income Disclosure Scheme.
• At the same time, demonetisation has the potential to generate long-term benefits in terms of reduced corruption, greater digitalization of the economy, increased flows of financial savings, and greater formalization of the economy, all of which could eventually lead to higher GDP growth, better tax compliance and greater tax revenues.
• The National Payments Corporation of India (NPCI) successfully finalized the Unified Payments Interface (UPI) platform. By facilitating inter-operability it will unleash the power of mobile phones in achieving digitalization of payments and financial inclusion, and making the “M” an integral part of the government's flagship “JAM”-Jan Dhan, Aadhaar, Mobile-- initiative.
• Further FDI reform measures were implemented, allowing India to become one of the world’s largest recipients of foreign direct investment.
• India is not only among the world’s fastest growing major economies, underpinned by a stable macro-economy with declining inflation and improving fiscal and external balances.
• The central government alone runs about 950 central sector and centrally sponsored schemes and sub-schemes which cost about 5 percent of GDP.

• Real GDP growth in the first half of the year was 7.2 percent, on the weaker side of the 7.0-7.75 per cent projection in the Economic Survey 2015-16 and somewhat lower than the 7.6 percent rate recorded in the second half of 2015-16.

• The Consumer Price Index (CPI)-New Series inflation, which averaged 4.9 per cent during April-December 2016, has displayed a downward trend since July when it became apparent that kharif agricultural production in general, and pulses in particular would be bountiful. 

• The decline in pulses prices has contributed substantially to the decline in CPI inflation which reached 3.4 percent at end-December.

• The second distinctive feature has been the reversal of WPI inflation, from a trough of (-)5.1 percent in August 2015 to 3.4 percent at end-December 2016, on the back of rising international oil prices. The wedge between CPI and WPI inflation, which had serious implications for the measurement of GDP discussed in MYEA has narrowed considerably. Core inflation has, however, been more stable, hovering around 4.5 percent to 5 percent for the year so far.

Political Carrying Capacity of the World for Openness (Current and Future)

		Today			Change in 10 years
	World	India	China	World	India	China	RoW
				(Fixed)			(Notional)
Exports of goods/world GDP	21.10%	0.40%	2.90%	0.00%	0.80%	1.40%	-2.10%
Exports of services/world GDP	6.10%	0.30%	0.40%	0.00%	0.50%	0.20%	-0.70%
Exports of goods and services/world GDP	27.30%	0.60%	3.30%	0.00%	1.30%	1.50%	-2.80%
Assumptions on GDP growth: World (3%), India (8%), China (5%)
Assumptions on export growth: World (3%), India (15%), China (7%)

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• The current account deficit has declined to reach about 0.3 percent of GDP in the first half of FY2017.

• Foreign exchange reserves are at comfortable levels, having have risen from around US$350 billion at end-January 2016 to US$ 360 billion at end-December 2016 and are well above standard norms for reserve adequacy. 

• In part, surging net FDI inflows, which grew from 1.7 percent of GDP in FY2016 to 3.2 percent of GDP in the second quarter of FY2017, helped the balance-of-payments.

• The trade deficit declined by 23.5 per cent in April-December 2016 over corresponding period of previous year. During the first half of the fiscal year, the main factor was the contraction in imports, which was far steeper than the fall in exports. But during October-December, both exports and imports started a long-awaited recovery, growing at an average rate of more than 5 per cent.

• Meanwhile, the net services surplus declined in the first half, as software service exports slowed and financial service exports declined. 

• Net private remittances declined by $4.5 bn in the first half of 2016-17 compared to the same period of 2015-16, weighed down by the lagged effects of the oil price decline, which affected inflows from the Gulf region.

• Excise duties and services taxes have benefitted from the additional revenue measures introduced last year. The most notable feature has been the over-performance (even relative to budget estimates) of excise duties in turn based on buoyant petroleum consumption: real consumption of petroleum products (petrol) increased by 11.2 percent during April-December 2016 compared to same period in the previous year. 

• Indirect taxes, especially petroleum excises, have held up even after demonetisation in part due to the exemption of petroleum products from its scope.

• The consolidated deficit of the states has increased steadily in recent years, rising from 2.5 percent of GDP in 2014-15 to 3.6 percent of GDP in 2015-16, in part because of the UDAY scheme.

• The spread on state bonds over government securities jumped to 75 basis points in the January 2017 auction from 45 basis points in October 2016.

• Demonetisation affects the economy through three different channels. It is potentially:

• An aggregate demand shock  because it reduces the supply of money and affects private wealth, especially of those holding unaccounted money;

• An aggregate supply shock to the extent that economic activity relies on cash as an input (for example, agricultural production might be affected since sowing requires the use of labour traditionally paid in cash); 

• An uncertainty shock because economic agents face imponderables related to the magnitude and duration of the cash shortage and the policy responses (perhaps causing consumers to deferor reduce discretionary consumption and firms to scale back investments).

• Demonetisation is also very unusual in its monetary consequences. It has reduced sharply, the supply of one type of money— cash—while increasing almost to the same extent another type of money—demand deposits. This is because the demonetized cash was required to be deposited in the banking system.

• The price counterparts of this unusual aspect of demonetisation are the surge in the price of cash (inferred largely through queues and restrictions), on the one hand; and the decline in interest rates on the lending rate (based on the marginal cost of funds) by 90 basis points since November 9; on deposits (by about 25 basis points); and on g-secs on the other (by about 32 basis points).

• Demonetisation coincided with the announcement of the US election results which also heralded a regime economic shift in the US. Hence, the impacts on India are compared with comparable emerging market countries to isolate, albeit imperfectly, the demonetisation effect.

• The most dramatic effect relates to interest rates. In almost all major countries, bond yields rose sharply after November 8, in the US by as much as 58 basis points as of January 19. In India, they had moved in the opposite direction by 32 basis points, a comparative swing of 90 basis points. Similarly, India’s stock market had declined by 0.93 percent.

• The decline in interest rates and the outlook triggered a large outflow of foreign portfolio investment, amounting to US$9.8 billion in November and December, with 60 percent of the decline accounted for by debt outflows.

• The balance of evidence leads to a conclusion that real GDP and economic activity has been affected adversely, but temporarily by demonetisation.

• The most appropriate gauge of demonetisation would be to compare actual nominal GDP growth or the Survey’s estimate of it with the counterfactual nominal GDP growth without demonetisation. According to the CSO this counterfactual is 11.9 percent, while the Survey’s estimate is around 11¼ percent.

• The IMF’s January update of its World Economic Outlook forecast is projecting an increase in global growth from 3.1 percent in 2016 to percent in 2017, with a corresponding increase in growth for advanced economies from 1.6 percent to 1.9 percent.

• We expect real GDP growth to be in the 6¾ to 7½ percent range in FY2018. Even under this forecast, India would remain the fastest growing major economy in the world.

• Currency shortages also affect supplies of certain agricultural products, especially milk (where procurement has been low), sugar (where cane availability and drought in the southern states will restrict production), and potatoes and onions (where sowings have been low).

• On the assumption that the equilibrium cash-GDP ratio will be lower than before November 8, the banking system will benefit from a higher level of deposits. Thus, market interest rates deposits, lending, and yields on g-secs should be lower in 2017-18 than 2016-17. This will provide a boost to the economy (provided, of course, liquidity is no longer a binding constraint).

• The government has acquired more credibility because of posting steady and consistent improvements in the fiscal situation for three consecutive years, the central government fiscal deficit declining from 4.5 percent of GDP in 2013-14 to 4.1 percent, 3.9 percent, and 3.5 percent in the following three years.

• The central government alone runs about 950 central sector and centrally sponsored sub-schemes which cost about 5 percent of GDP.

• One of the key problems with many programs is that the take-up and effectiveness of targeting will be correlated with a state’s institutional and implementation capacity. States such as Tamil Nadu and Andhra Pradesh, which do not necessarily have the largest number or proportion of poor avail themselves of the program to a greater extent than say Bihar which has many more poor people and a higher poverty rate.

• The world export GDP ratio has declined since 2011, and going forward a sharp rise in the dollar is expected with a corresponding decline in the currencies of India’s competitors, notably China and Vietnam. 

• Already, since July 2015, the yuan has depreciated about 11.6 percent (December 2016 over July 2015) against the dollar and as a consequence the rupee has appreciated by 6 percent against the yuan; the compulsions of delaying its rebalancing strategy might lead to a weak currency policy going forward, especially if there are continuous pressures for capital outflows.

• Since June 2014, when international oil prices started declining, India has increased its excise duties from Rs 15.5 per litre to Rs 22.7 per litre as of December 2016 for branded petrol and from Rs 5.8 per litre to Rs. 19.7 per litre for branded diesel.

• The increase in petrol tax has been over 150 percent in India. In contrast, the governments of most advanced countries have simply passed on the benefits to consumers, setting back the cause of curbing climate change. As a result, India now outperforms all the countries except those in Europe in terms of tax on petroleum and diesel.

• Having decisively moved from a regime of carbon subsidies, it is now de facto imposing a carbon tax on petroleum products at about US$150 per ton, which is about 6 times greater than the level recommended by the Stern Review on Climate Change.

• So far, and for the conceivable future, India’s reliance on fossil fuels remains well below China (the most relevant comparator) but also below the US, UK and Europe at comparable stages of development (this echoes the commitment made by India at Heiliengdamm that it would never exceed the per capita emission of advanced countries).

• In 2011, the Census reported that more than half of the country’s population defecated in the open. More recent data shows that about 60 percent of rural households (Ministry of Drinking Water and Sanitation- 2017; up from 45% NSS 2015) and 89 per cent of urban households (NSSO 2016) have access to toilets - a considerably greater coverage than reported by the Census 2011.

• For the majority of households without toilets, the Rapid Survey suggests some worrisome trends 76 percent of women had to travel a considerable distance to use these facilities. 33 percent of the women have reported facing privacy concerns and assault while going out in the open. In the face of these considerable risks, the number of women who have reduced consumption of food and water are 33 percent and 28 percent respectively of the sample.

• 2016 was a turning point in global demographic trends. It was the first time since 1950 that the combined working age (WA) population (15-59) of the advanced countries declined. 

• Over the next three decades, the United Nations (UN) projects that China and Russia will each see their WA populations fall by over 20 percent. India, however, seems to be in a demographic sweet spot with its working-age population projected to grow by a third over the same period; always remembering that demography provides potential and is not destiny.

• India’s demographic cycle is about 10-30 years behind that of the other countries, indicating that the next few decades present an opportunity for India to catch up to their per capita income levels.

• India’s WA to NWA ratio is likely to peak at 1.7, a much lower level than Brazil and China, both of which sustained a ratio greater than 1.7 for at least 25 years. Finally, India will remain close to its peak for a much longer period than other countries.

• There is a clear divide between peninsular India (West Bengal, Kerala, Karnataka, Tamil Nadu and Andhra Pradesh) and the hinterland states (Madhya Pradesh, Rajasthan, Uttar Pradesh, and Bihar). 

• The peninsular states exhibit a pattern that is closer to China and Korea, with sharp rises and declines in the working age population. The difference, of course, is that the working age ratio of most of the peninsular states will peak at levels lower than seen in East Asia (West Bengal comes closest to Korea’s peak because of its very low TFR). 

• In contrast, the hinterland states will remain relatively young and dynamic, characterized by a rising working age population for some time, plateauing out towards the middle of the century.

• Demographically speaking, therefore, there are two Indias, with different policy concerns: a soon-to-begin-ageing India where the elderly and their needs will require greater attention; and a young India where providing education, skills, and employment opportunities must be the focus.

• This demographic pattern will have two important growth consequences. First, it seems that the peak of the demographic dividend is approaching fast for India.

• This peak will be reached in the early 2020s for India as a whole.

• Peninsular India will peak around 2020 while hinterland India will peak later (around 2040).

• In other words, India will approach, within four years, the peak of its demographic dividend. (Note: this does not mean that the demographic dividend will turn negative; rather, the positive impact will slow down.)

Projected Demographic Dividend for India

Decade	Additional average annual PCI growth due to the demographic dividend (DD)	WA/NWA (WA/Total Population) at the start of decade
2001-10	1.44	1.33 (57.1)
2011-20	2.62	1.53 (60.5)
2021-30	1.81	1.81 (64.4)
2031-40	1.92	1.72 (63.2)
2041-50	1.37	1.72 (63.3)

• The good news is that there is a negative relationship, which means that on average the poorer states today have more of a growth dividend ahead of them. This means the demographic dividend could help income levels across states converge.

• Bihar, Jammu and Kashmir, Haryana, and Maharashtra are positive outliers in that they can expect a greater demographic dividend over the coming years than would be suggested by their current level of income. This extra dividend will help Bihar converge, while already rich Haryana and Maharashtra will pull further away from the average level of income per capita in India. 

• On the other hand, Kerala, Madhya Pradesh, Chhatisgarh, and West Bengal are negative outliers: their future dividend is relatively low for their level of income. This will make the poorer states fall back, unless offset by robust reforms and growth, while the relatively rich Kerala will probably converge to the average as its growth momentum declines rapidly.