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Were one to take official statistics strictly at face value, without any qualification at all, one would have to come to the conclusion that the government’s demonetization last November of the two largest existing banknotes – the Rs 500 and Rs 1,000 bills – had virtually no lasting effect on the economy. This is not to say that it did not create temporary problems, some of which are still making themselves felt. Reports from Mumbai, Bangalore, Chennai and other cities have it that ATMs are still running dry, on and off, since the Central Bank has been slow in printing and distributing the new banknotes and to date has replaced only about two-thirds of the total supply before demonetization. There are still problems in the informal economy, which is largely cash-based and accounts for some 70% of the employment in the nation.

While international credit managers report no difficulties with collections from Indian customers that are big companies, many small firms apparently are still slow payers, frequently blaming the “liquidity crunch” caused by Prime Minister Narendra Modi’s overnight move. Small service companies reportedly cut one-third of their workforce and lost half of their revenues in the month after demonetization. But real GDP still gained at an annual 7.0% in the final three months of last year, and this was down only modestly from 7.4% in the preceding quarter. In other words, it appears that, on the whole, the economy was able to shrug off quite handily the impact of the dramatic ban on 86% of the country’s cash.

The hope now is that Mr. Modi will keep the economy expanding as the year progresses, but there are still two potential pitfalls to be considered. One is the pending implementation of the Goods and Services Tax (GST) that has finally been passed by the Upper House of parliament. It is now to be introduced on July 1, or eleven years after it was first proposed in the legislature. No serious-minded analyst will deny that there is much to be said for replacing the hodgepodge of the local and state taxes that have been responsible for holding up goods at state boundaries, frustrating marketers and hurting the economy. The GST will turn India into a true single market for the first time and could be the most significant development for business since deregulation and privatization began in the early 1990s.

Following a series of political compromises, however, between New Delhi and states reluctant to lose control of their revenues, the GST – once intended to have a single, nation-wide rate – now has four different rates ranging from 5% to 28%, and which items will fall into each band has yet to be defined in detail. A council of state and national politicians is to meet next month to make final decisions on classifications, but this would leave businesses with just six weeks to prepare. So, now the government is being urged to delay the implementation by a chorus of voices from the very same business community that has been advocating such a reform for decades.

The second problem is the parlous condition of state-owned banks that have long been in denial about the ability of many of their near-bankrupt borrowers to repay them. This has led to the balance sheets of both the financial institutions and much of the corporate sector being in terrible shape and the authorities are now beginning to worry that the “twin balance sheet problem” could imperil the wider economy. Writing off loans might be a fair way out if banks could foreclose on companies and take equity in them instead. But this does not work well without a proper bankruptcy code, and such a law is only now coming into force and could take years to become fully effective. So, banks have been taking the easy way out, which has meant rolling loans over and extending new ones to keep their clients afloat in the hope that economic growth will eventually bail everyone out, meanwhile pretending that there is no real problem. The result is that USD 191 billion or 16.6% of the entire banking system is said to be non-performing and more than 40% of the loans extended to corporate India have gone to firms currently unable to pay even the interest on them (according to Credit Suisse).

In many other places this state of affairs would be tantamount to an acute crisis. In India, state-owned banks make up as much as 70% of the entire system and the government is not about to let them go belly-up. But the “twin balance-sheet” problem still hurts the economy as state lenders collectively show negative returns (13 of them were recently described by the Finance Ministry as “severely stressed”). They have become choosier in their lending, but even if this were not the case there might not be much demand for extra credit. Corporate profits have been shrinking at large borrowers, capacity utilization is low by historical standards, investment has been contracting and economic growth is being driven almost exclusively by consumption. From a longer-term perspective, this is not a good situation.

Global Perspectives by Dr. Hans Belcsak