Demonetisation Impact To Persist Till FY17 End But Timing Was Right: IMF
India’s real GDP growth is projected to slow down to 6.6 percent in Q4FY17.
The government's decision to demonetise old high-value currency notes is likely to keep India's economic growth subdued at least through the first quarter of 2017, said the International Monetary Fund (IMF) in its Article IV consultation paper on India. The Article IV consultation is a periodic stock-taking exercise that the IMF conducts for member countries.
India’s real gross domestic product (GDP) growth is projected to slow to 6.6 percent in the current fiscal and then rebound to 7.2 percent in the next, due to temporary disruptions caused by the cash shortage, the IMF said.
These effects are expected to gradually dissipate by March 2017 as cash shortages ease and would be offset by tailwinds from a favourable monsoon and low oil prices, and continued progress in resolving supply-side bottlenecks.IMF Article IV Consultation Paper On India
IMF's staff analysis suggested that cash shortages will hit FY17 growth by one percentage point, while growth in FY18 will be lower by about half a percentage point.
Strong consumer sentiment will support near-term growth recovery once the cash shortage eases, the paper added.
Demonetisation is also expected to take a toll on the recovery of investments. The IMF said that the investment recovery will remain modest and uneven across sectors even as deleveraging takes place and industrial capacity utilisation increases.
On November 8, 2016, Prime Minister Narendra Modi stripped the nation of 86 percent of the currency in circulation by invalidating old Rs 500 and Rs 1,000 bank notes. The purchasing managers' index (PMI) in manufacturing and services declined sharply reflecting a drop in output and new orders, and consumption slowed. As the stock of new currency has increased, there has been a marginal rebound in indicators like the PMI.
Despite the adverse impacts, the timing of the note ban exercise was right because India had stable macroeconomic conditions which would help the economy withstand short term pressures, said Subir Gokarn and Himanshu Joshi – India’s representatives at the IMF.
The steadfast advice from the Fund to member countries is to carry out structural reforms when macroeconomic conditions are hospitable, which can help in minimizing the disruptions and speeding up the return to normal. The current macroeconomic situation in India – relatively rapid growth, relatively low inflation, fiscal consolidation on track and a relatively low CAD (Current Account Deficit) – provides the right environment in which to launch initiatives of this kind; the impact and persistence of any disruptions are likely to be minimized in these conditions.Subir Gokarn and Himanshu Joshi, IMF
The IMF added that the success of this initiative will largely depend on the effective implementation of anti-money laundering measures and countering terrorism financing, especially through banking and commodity markets.
Red Flag For Banks
IMF's consultation paper also cautioned on the health of the banking sector, especially that of the public sector banks, as a mix of challenges remain.
Recognition of non-performing assets (NPAs) by banks saw an uptick due to the Reserve Bank of India's asset quality review (AQR) which began in 2015. The NPA slippage ratio accelerated to 7.2 percent in FY16 compared to 3.4 percent in FY14.
While this pushed banks to increase their bad loan provisioning, it impacted the profitability of public sector banks, the IMF noted.
The return on assets of public sector banks turned negative in FY16. The provisioning coverage ratio, too, remained low at 39 percent at the end of the same fiscal. This, according to IMF, raises concerns about their sufficiency.
The financial performance of Indian corporates is improving but the high concentration of debt in certain industries like metals and mining, construction and engineering, and transportation and infrastructure poses great risks to banks’ financial health.
With the corporate sector accounting for about 40 percent of banks’ credit portfolios, the soundness of the banking sector and its ability to provide effective intermediation in the economy thus rest on effective deleveraging and debt restructuring in the corporate sector.IMF Article IV Consultation Paper On India
The high corporate leverage could aggravate the bad loan situation for the Indian banking system, the IMF added.
The limited monetary and fiscal space in India constrains policymakers’ capacity to counteract any additional increase in NPAs due to a long gestation of corporate projects or further domestic or external shocks.IMF Article IV Consultation Paper On India
The rising NPAs put strain on the banks' capital reserves, at a time when the central bank wants lenders to adopt Basel-III norms by FY19.
The IMF said the government may have to provide the additional funds to public sector banks to meet that target.
The recapitalisation of public sector banks would cost about 1.5-2.4 percent of the FY19 GDP, and will have a modest fiscal impact, projected the IMF.
The government's share would translate to 1-1.6 percent of the GDP. This calculation is inclusive of 0.5-0.8 percent of the FY19 GDP going towards bank recapitalisation.
These calculations are based on a number of assumptions which includes 25 percent of the restructured loans turning into NPAs, banks setting aside a minimum provisioning coverage ratio of 40 percent, and build up an additional zero to two percent of capital buffer.
However, more conservative provisioning requirements would result in considerably higher costs of recapitalisation, IMF added.