Demonetisation impact: World Bank drops India's growth rate to 7%

The World Bank today decelerated India's growth for 2016-17 fiscal to a "still robust" 7% from its previous estimate of 7.6 due to demonetisation, but asserted that the country would regain momentum in the following years with 7.6 and 7.8% growth.

"The immediate withdrawal of a large volume of currency in circulation and subsequent replacement with new notes announced by the government in November contributed to slowing growth in 2016," the World Bank said in its latest report.

In its first report after November's demonetisation, the World Bank said, "Indian growth is estimated to have decelerated to a still robust 7% (in fiscal 2017 ending on March 31, 2017), with continued tailwinds from low oil prices and solid agricultural output partly offset by challenges associated with the withdrawal of a large volume of currency in circulation and subsequent replacement with new notes."

Notably, India maintains the distinction of being the fastest growing emerging market economies of the world, bypassing China.

"India is expected to regain its momentum, with growth rising to 7.6% in Fiscal Year(FY) 2018 and strengthening to 7.8% in FY 2019-20," the Bank said, adding that various reform initiatives are expected to unlock domestic supply bottlenecks and raise productivity.

Infrastructure spending should improve the business climate and attract investment in the near-term, it added.

"The 'Make in India' campaign may support India's manufacturing sector, backed by domestic demand and further regulatory reforms. Moderate inflation and a civil service pay hike should support real incomes and consumption, assisted by bumper harvests after favourable monsoon rains," the Bank said in its latest report Global Economic Prospects.

"A benefit of 'demonetisation' in the medium-term may be liquidity expansion in the banking system, helping to lower lending rates and lift economic activity," the World Bank noted.

Noting that in India, cash accounts for more than 80% of the number of transactions, the World Bank observed that in the short-term, 'demonetisation' could continue to disrupt business and household economic activities, weighing on growth.

"Further, the challenges encountered in phasing out large currency notes and replacing them with new ones may pose risks to the pace of other economic reforms (e.g. Goods and Services Tax, labour, and land reforms)," it said.

"Spillovers from India to Nepal and Bhutan, through trade and remittances channels, could also negatively impact growth to these neighbouring smaller economies," the Bank noted.

According to the Bank, India's growth in the first half of FY 2017 was underpinned by robust private and public consumption, which offset slowing fixed investment, subdued industrial activity and lethargic exports. 

Consumption was supported by lower energy costs, public sector salary and pension increases, and favourable monsoon rains, which boosted urban and rural incomes, it said adding that economic activity also benefited from a pickup in foreign direct investment (FDI) and an increase in public infrastructure spending.

"Unexpected "demonetisation'the phasing out of large-denomination currency notes which were subsequently replaced with new ones?weighed on growth in the third quarter of FY2017," the World Bank said.

Weak industrial production and manufacturing and services purchasing managers indexes (PMI), further suggest a set back to activity in the fourth quarter of FY2017, it added.

"For the whole of FY2017, growth is expected to decelerate to a still robust 7.0%." In its report, the Bank said there has been slowdown in investment in South Asia.

"In India, gross fixed capital formation has been on a downward trend since 2011, with a shift in the composition from private to public," it said.

While public investment rose by 21% in FY2016, private investment (which accounts for two-thirds of the total) contracted by 1.4%, reducing overall investment growth to 4%.

Infrastructure demand is expected to go up to $1 trillion under the 12th Five-Year Plan (2012-2017).

"Going forward, public and private investment should be supported by higher allocations in the FY2017 federal government budget to build and upgrade infrastructure, and the setup of a $3 billion National Investment and Infrastructure Fund," it said.

According to the Bank, India's steep private investment slowdown has been attributed to several factors. The need to unwind excess capacity built during the pre-financial crisis growth boom amid weak external demand (eg in the manufacturing sector) has discouraged new projects and caused investors to shelve existing projects, it said.

"Second, policy uncertainty has been a factor," it said.

For example, the stalled Land Acquisition Bill has extended project development timelines. Lack of federal and state government coordination, on compensation for land acquisition and environmental clearances, has contributed to cost and time overruns.

Also lenders have been less willing to finance overleveraged corporates, especially in infrastructure related sectors (eg power and other utilities, steel, and cement firms).

In particular, the Reserve Bank of India's 2015 corporate governance reforms in state-owned banks (which represent two-thirds of the total banking sector lending) has adversely affected lending to leveraged corporates and conglomerates, the report said.