8 challenges for Indian economy in 2017

Despite doubts raised about India’s GDP numbers, the fact remains that India is one of the fastest growing large economies. This, however, doesn’t mean there are no downside risks going forward. Here are eight such risks:

1.Vulnerability of rupee to increase in 2017 because of the following: i) rising crude oil prices after OPEC deal on production cut that will push up import bill ii) slower growth of goods exports (vis-à-vis imports) because of bleaker global macroeconomic environment caused by rising protectionism, uncertainties created by the unexpected outcomes of referendums in Britain and Italy and Trump’s Presidency, iii) sluggish services export, iv)US fed hikes that will reduce interest rate gap between India and the US and induce capital outflows from India’s debt market v) slowing net FDI inflows and remittances vi) weakening yuan that may make RBI tolerant of further slide in rupee to relative export price disadvantage

Things are still not as bad as they were in 2013 though the downside risks are increasing. That will keep rupee volatile and weak in 2017. Given the substantially high proportion (60%) of India’s external commercial borrowings ($182 billion) unhedged, weakening of rupee will complicate things for many corporates.

2. Macroeconomic stability will be under pressure in 2017: Continued low commodity prices especially of crude oil have helped Indian government contain fiscal deficit and rein in inflation. However, oil prices are hardening again after the successful conclusion of OPEC deal on production cut and willingness of non-OPEC members to join it. That is not good for India’s current account balances. Besides, it is likely to push up government’s subsidy bill and aid inflation. That may explain why RBI kept benchmark interest rate unchanged in its latest revision on Dec 7 even though consumer inflation is well below the target of 4%.

3. Growing divergence between consumption and investment: While consumption has remained steady (growing at 8% plus) at least till demonetization was introduced, investment as measured by gross fixed capital formation has been in the negative zone for the last three quarters because of deleveraging of corporate balance sheets, lower capacity utilization (below 75%) and demand slump in both domestic as well as export markets. It fell 1.9% in last quarter of FY 2015-16; then again fell 3.1% in first quarter and 5.6% in the second quarter of the current financial year. That can’t be sustainable in the long run as rising oil prices and increased spending on implementation of 7th Pay Commission award will limit the government’s ability to spend on infrastructure and other productive ventures especially at a time when India Inc is more indebted and vulnerable than it was in 2008 and private sector investment is not happening. That may impact India’s growth prospects in 2017.

4. Demonetization jolt to India’s growth story is likely to continue even in 2017: If investment slump was not enough, demonetization induced reduction in consumption demand and resultant decline in the sales of businesses will disturb capex plans especially in the SMEs sector that accounts for 45% of India’s manufacturing GDP and 40% of its merchandise exports. It is also likely to eat away part of the benefit of good monsoon. Together, these developments may chop off anything between 0.5% and 2% of the country’s GDP. Despite the claims that things will soon normalize, government doesn’t seem to have a clue about when queues at banks will subside and economic activities will be back to its normal.

Worse, it now looks like most of the demonetized currency notes will return to the banking system, so no windfall gains to government happening from destruction of black money to the extent of 20% of the value of 500 and 100 currency notes in circulation as initially estimated. Now the government is claiming that the move will encourage digitization of financial transactions. Sure, it will, but not much as many think given the low access and concerns on quality of internet in smaller towns and rural areas.

5. GST conundrum: An increasing number of analysts are now speculating on whether GST will be implemented from 1st April, or if not 1st April, then 1st Sept. After that, it would be too difficult politically as constitutional deadline will expire on Sept 30. Given the logjam at GST council and demonetization-induced political turmoil in the country, it’s not an easy question to answer. With multiple tax rates, numerous exemptions, and pushing and shoving between New Delhi and Indian states for control, doubts over the quality of implementation have increased. Multiple GST rates also mean there will be unending classification disputes and scope for discretion and inspector raj is not going away anytime soon. So, the estimated benefited to the tune of 1-2% of the GDP may not happen.

Then there is no clarity on how well prepared are the corporates to adjust with the new indirect tax regime. Besides, SMEs/informal sector which have been hit hard by demonetization are also the one to be hit hard by GST – that should be another worry for policy makers as over 90% of India’s workforce is employed by this sector.

6. The problem of jobless growth will continue to haunt India in 2017 - accentuated by rising unemployability of college graduates, outrage against outsourcing, trade protectionism, demand slowdown and not much improvement on ease of doing business front. That has the potential to gradually turn the country’s demographic dividend into demographic disaster with serious long term implications for demand for homes and consumer goods.

7. The menace of NPAs will continue to grow in 2017: Despite a series of government measures to deal with bad loans and relentless efforts by RBI, gross non-performing assets of state owned banks rose to INR 63.03 trillion on Sept 30 from INR 55.03 trillion on June 30. Many analysts opine that things are not so bad for private sector banks (Gross NPAs for ICICI Bank stood at 6.28%, followed by Axis Bank at 4.17% compared to state owned bank IOB at 21.7% or PNB/BOI at 13%) but private sector banks have avoided risky corporate loans which are needed to support industrial expansion. Yet there is no denying that PSU banks don’t always give loans on commercial considerations alone, and that may explain their unsustainably high share of bad loans.

Indian banks are also forced to write off bad loans mostly given to larges corporates. Because of rising NPAs and write offs, banks are not able to pass on the benefit of policy rate cuts (175 basis points since Jan 2015) to borrowers especially retail borrowers and SMEs that will have adverse implications for India’s growth prospects going forward.

8. India’s realty mess to worsen in 2017: Total outstanding credit to realty companies as on August 30 2016 stood at INR 1.81 trillion, in addition to the retail housing loans of INR 7.46 trillion as on March 30, 2016. Thus, Indian banking system is over-exposed to the real estate sector which is suffering from buyer’s disinterest accentuated by the unwillingness of unscrupulous builders to meet their basic contractual obligations on timely delivery and quality, and now demonetization.

Yet, state-after-state are trying to dilute major provisions of the Real Estate (Regulation & Development) Act 2016 that may go against realty companies, but are needed to restore home buyers’ trust in this sector and bring them back to consider buying properties.

Delayed completion of the realty projects slows the demand for not only inputs such as cement and steel (supplied by large companies) but also the demand for services such as electrification, plumbing, wood work and interior decoration – mostly supplied by SMEs. As a result, slump in realty market will have a wider negative impact on India’s overall growth prospects.

With real estate prices showing downward trend that is likely to continue for quite some time, many believe that India’s banking system which has huge outstanding loans to recover from builders and buyers, and politicians who remain invested in property markets, will not let property prices to fall below a certain level. Further, like in 2008-09, lower interest rate induced bank credit may come to the rescue of troubled real estate sector in 2017.

However, things are different now, in at least five ways: i) mismatch between what most buyers want (affordable homes) and what most builders (pricey premium homes) are selling; homes prices at current levels are un-affordable to most end users, ii) buying homes at current prices doesn’t also make sense for investors if looked from the perspective of rent/capital value ratio i.e. 2 to 3% compared to 6-10% in most developed countries, iii) relatively higher cost of capital (9%) in India v/s 2% in developed markets also makes buying homes in the country a bad idea especially when prices are going down iv) most builders are defaulting on timely delivery and promised quality that had driven away buyers from market, and v) banks, especially PSUs themselves are facing a twin problem of high NPAs and capital shortage that will keep them less adventurous this time while sanctioning loans irrespective of interest rates. 

With sales really down, realty companies are already finding it difficult to repay bank loans and are forced to rely on high cost PE or loan sharks. Seeing the value of their properties falling down, what if property buyers start surrendering their mortgaged properties to banks something like what happened in the US?

That will further push down home prices and scare away prospective buyers of all kinds – end users and investors, and we’ll have a full-blown housing market crash with prices falling by 30-60%. That will be a big problem of India’s banking system.

Thus, given the slowing credit demand, unsustainably high and rising NPAs of Indian banking system and its over-exposure to troubled realty sector if housing market really hard lands it may lead to a banking crisis in near future if not in 2017. That may keep India away from double digit growth rates for long despite the hype about its better economic fundamentals.

My new-year question therefore is: Is India headed for a banking crisis in 2017?

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Additional note: Indian equity market has not seen much support from FPIs with India receiving a net equity flows of $ 6 billion in the last two years (2015 & 2016) compared to $60 billion in previous three years (2012, 2013 & 2014)

A shorter version of this post has been published by BrinkAsia here.

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