After the storm

The NDA government has long been aware that the 'nationalism' plank can deliver limited results and the party must explore another plank on the basis of which it can attract votes. In a bid to close this gap, the promise of 'development' and 'jobs' was the core calling card that the NDA deployed in the 2014 general elections. Now that it is clear that progress on the job-creation front has been patchy, it would appear that the government was keen to tap into another economic issue with cross-sectional appeal. Enter the black-money crackdown, a theme which clearly has mass appeal.

Additionally, it seems like the black-money crackdown is propelled by the PM's desire to create a 'new equilibrium' for the broader economy - an equilibrium in which the routine evasion of tax, minimum wages and myriad other industrial laws is minimised. Hence, the logical next step is likely to be to launch more measures to curb the size of the black economy.

These measures could potentially include bans on cash transactions exceeding a certain threshold, seizure of properties where the title cannot be verified, seizure of gold where the owner cannot show proof of purchase/inheritance, prosecution of those who have used Jan Dhan accounts to launder their wealth, punitive taxation of those who have used their bank accounts after November 9th to park black money, etc. In short, the PM, emboldened by the knowledge that his pursuit is morally appropriate, is likely to be determined to do whatever it takes to emerge triumphant in this crusade against black money.

Against this backdrop, the budget FY18 announcement assumes tremendous importance as it will be the first major government announcement following the decision to demonetise 86 per cent of the total currency in circulation, which has created a great deal of hardships for the common man. We expect the budget for FY18 to be characterised by three sets of features, namely, (1) a significant increase in fiscal transfers for the lowest economic strata, most probably in the form of a pilot 'universal basic income' scheme; (2) a deviation of about 30 bps from the stated fiscal deficit target of 3 per cent of GDP in FY18; and (3) improved monitoring mechanisms for property-tax collection and a reduction of subsidies for the rich.

With regards to GDP growth, we expect it to decelerate from 6.4 per cent in H1FY17 (as per Ambit's estimate) to 0.5 per cent YoY in H2FY17. Several commentators have published learned critiques of our growth estimates and whilst we are happy to admit that our growth estimates might not be precisely right (given the surreal GDP growth estimates that have been emanating from the government over the past couple of years), we are confident that our estimates capture the broad impact on a largely cash-based economy of a radical reduction in the amount of cash in circulation.

Furthermore, we expect investment growth to remain weak in FY18 as a shell-shocked private sector tries to absorb the ongoing battering of the black economy. To some extent, the weakness in investment will be compensated by an increased growth in government expenditure and consumption. Thus, GDP growth should recover from 3.8 per cent in FY17 to between 5-6 per cent in FY18. That being said, given that the PM does not have a reputation for handing dole-outs, it would be unwise to expect the government to support consumption beyond a point.

In light of the above, the first half of calendar year 2017 looks likely to bring copious amounts of bad news of corporate earnings (which have barely grown in India over the past four years). This in turn seems likely to presage a correction in the stock market as domestic investors, whose inflows have neutralised foreign investors' outflows over the past year, finally throw in the towel. This correction in the stock market will particularly impact companies which lend money to small businesses and the companies which are plays on the construction cycle.

However, over a 18-24-month horizon, the broader market should rally as it becomes apparent that the NDA's attack on black money is delivering a more efficient economy with a lower cost of capital, lower cost of land and real estate, less tax evasion, and a smaller unorganised sector. The big winners over a longer-term horizon will therefore be sector-leading franchises with strong balance sheets, high-quality management teams and, ideally, the ability to consolidate smaller players in their sectors and then become large-scale global exporters. Hence, we are likely to see more structural change in the Indian economy over the next two years than we have seen in the last two decades.

The main risk to the above hypothesis is the UP assembly election in spring 2017. UP is not only the most populous state in India, it is also politically the most important state in India, with the most number of seats in the Lok Sabha. The UP elections will be an acid test of the political viability of demonetisation. The results of UP elections will reveal if an all-out attack on black money delivers votes. A reverse in this key assembly election could lead to the above narrative coming under pressure.