By now, it is quite known and accepted that the near-term impact of demonetisation on various sectors (both consumption and production) is going to be sharp, but would be gradually positive in the medium-term. We reduce FY17/18 GVA by 100/80bps to 6.8%/7.4%. We anticipate a 75-100bps cut in repo rates and believe that the Indian government will fully use all savings from lower currency liability and spread it over the next two years, not just over FY18. Depending on the quantum of savings, it could spread spending over all sections of the economy – rural, capex, infra, defence, railways, bank recapitalisation, and tax sops. Thus, a huge fiscal stimulus is likely in FY18-19. If this is how it plays out, in a few months, public-spending oriented sectors could gain more traction over consumption-oriented ones.
Growth could be dented for the next year
Curbs on black money are likely to hurt consumption, manufacturing, and services – which would severely dent 2HFY17 GVA. Job losses for the labour class will be deep. Credit growth will slow to a crawl. An added issue in 1QFY18 will be GST, which will keep growth prospects under pressure. We see gradual improvement in 1HFY18 and a better pick-up in 2HFY18. FY19 should be the year of gains though, when GVA growth would cross 8%. Some of the damage from demonetisation is likely to be permanent. A likely fiscal stimulus in FY18-19 will be the key for an economic recovery.
Inflation and interest rates could soften even further
Inflation in FY17 is likely to drop to 3.5-4.0%, and to 4.0% in FY18. Our FY17 inflation assumptions are based on subdued food inflation, continuing transportation assistance under currency demonetisation, normal rabi sowing, and stable commodity prices. Modest inflation trajectory along with RBI's real-interest range is likely to usher in a 75-100bps repo rate cut over the next year. 10-year G-sec yield should be 6% by March 2017 and 5.5% by March 2018. Sharp banking transmission is likely in the next few weeks to months.
Fiscal deficit to consolidate for centre, widen for states
Fiscal deficit for FY17 will be 3.5% of GDP, as budgeted by the government. We expect government spending to take a dip in 2HFY17 due to the financial squeeze led by demonetisation. For FY18, the government is likely to introduce a fiscal deficit range – we expect it at 3.0-3.2%. Incremental funds are likely to result in higher spending, rather than fiscal consolidation (assuming that the government gains Rs 2-3tn and it is spread over the next two years). In case the RBI transfers the entire amount to the government in one year, there is large scope for fiscal consolidation. The government is likely to use these funds in the form of tax cuts (direct and indirect), higher social and capital spending, and sops for the rural sector. FY18 is also the year of GST implementation.
CAD to widen in FY18 due to oil; capital flows to strengthen
We estimate CAD for FY17 at 0.5%, widening to 1% in FY18. Exports growth in FY18 is likely to be lower than FY17, as we see limited progress in the global growth scenario. Imports are likely to rise reasonably (PC: +6% yoy), assuming higher crude oil price of US$ 55 vs. US$ 48 for FY17. Net invisibles are likely to improve only marginally to US$ 106bn due to sluggishness in software exports and remittances. Capital flows should widen to US$ 63bn from US$ 39bn in FY17, resulting in a BoP surplus of US$ 33bn. We see average USD-INR rate at 67 for FY17 and 67.50 for FY18.
Risks: Future government policies, currency, Trump policies, oil prices, GST, and monsoon
There is a rising risk that the Indian government could implement more measures to curb black money, and while these are long-term positives, they will be damaging for growth in the short term. USD-INR is at an all-time high and further weakness and persistence at higher levels will dent FII flows. Trump's policies, their currency impact, oil prices, GST tax rate, and monsoon are other risk factors for the next year
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