Announcement: Moody's and ICRA: Indian economy to remain strong in 2017, despite short-term impact of demonetization

Moody's Investors Service and its Indian affiliate, ICRA Limited, say that India (rated Baa3 positive by Moody's) will remain one of the fastest growing major economies globally in 2017, although GDP growth will moderate in the first half of the year, as the economy adjusts after demonetization. Moody's also believes that the government will likely achieve its fiscal deficit target of 3.5% of GDP for the current fiscal year ending 31 March 2017.

ICRA expects the country's growth of gross value added at basic prices to remain healthy in 2017, although such growth will ease somewhat to about 6.6% from around 7.0% in 2016, with a likely pick-up in H2 2017.

"Even after the currency in circulation is replenished, we expect that India's economic growth will stabilize with a lag, while remaining strong," says Aditi Nayar, an ICRA Principal Economist. "The adjustment and recovery period could stretch to as much as 2-3 quarters for certain sectors."

ICRA says that the focus on digital transactions and the introduction of a goods and services tax (GST) will likely reduce the competitiveness of the unorganised sector. ICRA therefore anticipates a relatively healthier expansion of the organised sectors in 2017, at the cost of the unorganised sectors.

ICRA further points out that the low agricultural growth in H1 2016, as well as healthy reservoir levels on a seasonally adjusted basis, will support the pace of expansion of agricultural output in the first half of 2017. But agricultural growth in subsequent quarters will be influenced by various factors, the most important being the magnitude and dispersion of monsoon rainfall.

ICRA also says that the loss of incomes in some sectors and deferral of consumption are likely to weigh on capacity utilization, delaying the capacity expansion plans of the private sector. And, the extent of capital spending budgeted by the central and state governments for the fiscal year ending 31 March 2018 will affect the extent to which infrastructure spending can stimulate growth in a non-inflationary manner.

"Nevertheless, economic and institutional reforms already introduced and potentially forthcoming, continue to offer a reasonable expectation that India's growth will outperform that of its similarly rated peers over the medium term, and that the country will achieve further improvements in its macroeconomic and institutional profile," says William Foster, a Moody's Vice President and Senior Credit Officer.

Moody's and ICRA point out that after a temporary dampening effect on consumption and investment in the medium term, demonetization will likely strengthen India's institutional framework — by reducing tax avoidance and corruption — and should support efficiency gains through a greater formalization of economic and financial activity.

Moody's also points out that in an environment of lackluster global trade, and with economies globally facing the increasing risk of protectionism, India's very large domestic markets provide a relative competitive advantage when compared to smaller and more trade-reliant economies.

On the fiscal front, Moody's says that the government will likely remain committed to achieving its fiscal deficit target of 3.5% of GDP for the fiscal year ending 31 March 2017. However, room to reduce the deficit further to the target of 3.0% of GDP in the following year will be limited, due to the need for increased infrastructure spending and higher government salaries.

The government announced its intention to increase public capital expenditure in the last budget to help reduce supply-side bottlenecks and stimulate growth. Meanwhile, wages and salaries account for about 50% of total fiscal expenditure, with a large, one in 10-year increase in central government compensation just implemented. Moody's expects that the government will renew its commitment to increase capital spending and address the short-term disruptive impact of demonetization, during its budget speech on 1 February 2017.

Moody's explains that the implementation of the pending GST and other measures aimed at enhancing income declarations and tax collection will help widen India's tax base and boost revenues. However, such a boost will only materialize over time, with the magnitude uncertain at this point.

As a result, the general government deficit will remain sizeable, and any reduction in India's government debt burden will largely rely on robust nominal GDP growth. Moody's expects that India's debt-to-GDP will hover around the current levels (at 68.6% in 2015) before falling gradually, as nominal GDP growth is sustained and revenue-broadening and expenditure efficiency-enhancing measures take effect.

On the issue of average CPI inflation, ICRA says that the rate will soften to 4.5% in 2017 from 4.9% in 2016, although the readings will continue to register month-to-month volatility. Key factors that will dominate CPI inflation in 2017 include monsoon dynamics, the impact of the GST on prices of various goods and services, commodity price movements, and the INR-USD exchange rate.

ICRA says that based on the minutes of the Monetary Policy Committee's December 2016 meeting — which revealed a renewed emphasis of some members on achieving the mid-point of the inflation target range of 4% — the room for incremental repo rate cuts will prove limited, at 25 basis points over the next six months.