The impact of India’s goods and service tax (GST) is becoming more evident across both economic data and corporate earnings. Economic growth for the June quarter grew just 5.7% YoY, lower than expectations, while the slowdown was also underlined when India’s Nikkei Market PMI for July contracted for the first time this year. 1Q18 (month end June 2017) corporate announcements which already took into account demonetization from last year are citing front-loaded demand and destocking ahead of GST implementation. GST has become an easy scapegoat for the general level of softness in economic momentum, but any suggestion that the disruption provides pretext for a policy reversal or resumption of wasteful government subsidies is misplaced, in our view.
Similar worries surfaced following November’s demonization as the surprise announcement was seen as current administration’s ongoing efforts to address illegal and black money. The disruption was palatable, as party opposition argued that the move did little to address the root cause, spurring public distrust towards government policies. But despite the nationwide inconveniences reported, the establishment of policy frameworks and supportive financial inclusions kept these grievances limited.
The same fate holds for GST as the government‘s response will determine the extent of the policy’s success. Political capital is extremely underestimated in India, as Prime Minister Modi has maintained an elevated approval rating since taking office. Notwithstanding vocal complaints, the general public acknowledges perennial benefits over the temporary inconvenience. This patience will again be tested but the business community appears better prepared, as GST was well advertised, albeit scant on particular details, unlike demonetization which came as a surprise.
The medium and longer-term benefits are also attractive. India’s cascading tax regime was not only inefficient for businesses but translated into higher operating costs and further deepened the country’s informal economy. This mattered as monetary and fiscal policies are less responsive in fragmented economies. Without formalization, households and businesses remained susceptible to leakages and middlemen which translated to margin erosion and corruption, particularly in rural parts of the economy which have not benefited as much from India’s rapid growth.
Worries arise if the economy were to derail on account of GST and subsequently lead to a policy reversal. In addition to the Reserve Bank of India cutting interest rates during the August meeting, farm-loan waivers, where central and state governments write off bad loans have emerged as early indicators that PM Modi and the Bharatiya Janata Party (BJP) are reverting away from their reform agenda. But the slowdown in economic momentum is likely short-lived as the environment remains conducive for growth.
Falling oil prices should maintain purchasing power for private households and disposable income levels, offsetting any inflationary pressure as a result of GST and subsequent higher prices.
Pent up demand should feed into a new restocking cycle as policy clarity improves while new infrastructure and public housing projects should spur private investments and corporate capex. Helping implementation is also the apparent effort from other Southeast Asian economies pushing similar tax reforms. Members of the ASEAN community including Malaysia, Indonesia and the Philippines have, in one form or another, simultaneously removed wasteful subsidies while raising government revenues. These decisions have helped limit the rise of populist groups more evident in developed countries and builds fiscal capacity for counter cyclical spending.
With a fragmented opposition party, Prime Minister Modi’s political capital should allow him and the BJP to advance economic reforms. Overseas policies are always a concern for markets, including renewed protectionist rhetoric or territorial disputes. However, regional policies remain practical and look to seek common ground. This was recently demonstrated following the China and India standoff in the Himalayan mountain region, as both were able simultaneously to save face but appear tough for their domestic constituents, recognizing the need for diplomatic backpedaling and the avoidance of any aggressive foreign policy mishaps.
Early signs of the restocking had begun to take place, as many had anticipated budding recovery by the September quarter. However, heavy rains across South Asia likely delays this cycle. Flooding is unlikely to derail economy growth, as flood loss as percentage of GDP has fallen over the past several decades. Given the impact to several key states, the severe weather perhaps provides the political onus to push forward infrastructure projects which have been delayed due to bureaucratic red tape.
The aforementioned should extend year to date returns for equities as risk appetite from both foreign and domestic investors remain high. There is scope to take a more optimistic view should the government implement direct farm investments, particularly in agricultural sectors that improve crop yields and production. The irony, of course, is that much of this will become more effective over time, given that the agricultural economy is highly fragmented.
Fund Manager - Asia