The best time to introduce a demonetization programme, which inevitably hits consumption in the first instance, is to do so when either the investment cycle or the export cycle is on an upswing. Neither of these conditions is in place. Indeed, the capital goods cycle, judging from industrial production and GDP number, is particularly weak. That will now be joined by declining consumption spending for a few months at least till the fourth quarter.
Longer term, the theory goes that the economy will be better off because there will be more activity in the formal sector, transactions will be more efficient and the government will be able to collect more taxes and thus spend more. I am far from convinced that this is a net long-term positive.
The economy will be more formalized but that does not guarantee that there will be higher spending or better spending. As for the government collecting more tax, yes, but is that a good thing? It is a big assumption to make that the government will spend money more wisely than private individuals. Maybe Modi's government will but would we have trusted (Manmohan) Singh's government to do so? I wouldn't have made that leap of faith.
India will continue to be a great growth story in coming years relative to the rest of the world but will it now step up a gear or shift down a gear? I think the answer is that we just don't know nor will we ever have the counterfactual to test whether the experiment worked or not.
The demonetization exercise along with the introduction of GST should provide a windfall for government coffers. This is exactly the time that the 3% deficit target should be underlined and hardened.
India is still a bright spot in terms of growth potential. Moreover, yields on Indian sovereign debt are extremely attractive in a global context while the rupee is undervalued. There is a lot still right with India and the overall growth story has not changed.
We think that the worst of the recent sell-off in emerging markets over. There is too much enthusiasm for the promises made by Trump and not enough recognition of the economic reality. The strength of the dollar will further worsen conditions there by squeezing both profits and exports. We are looking for the dollar and bond yields to reverse as it becomes more evident that the US is heading towards recession, not boom. Durable goods, real retail sales, investment spending, industrial production and corporate profits are all weak. Only the labour market looks strong and it has never been a good lead indicator.
The Fed hinted at four rate hikes in 2016 when it raised rates a year ago. It managed one. We believe that it will deliver one more rate rise in the next three months before generalized weakness in the US economy becomes evident and the rate rises are reversed. QE4 is likely to be introduced sometime this year.