OECD sees India's growth at 7% due to note ban, bats for inheritance tax

The Organisation for Economic Co-operation and Development (OECD)  has projected India's economy to grow 7 per cent in the current financial year and rise gradually to 7.3 per cent in the next year and 7.7 per cent in 2018-19.

In a report titled, 'Economic Surveys India' released on Tuesday, OECD says implementing the demonetisation has had transitory and short-term costs but should have long-term benefits. 

It prescribes that India should bring down corporate tax rate to 25 per cent, introduce inheritance tax and provide certainty in rules.

The Central Statistics Office will release second advance estimates for gross domestic product (GDP) for 2016-17 and actual figures for the third quarter of the year. It had projected the economy to grow 7.1 per cent during the current financial year in its first advance estimates against 7.9 per cent in the previous financial year. 

OECD says the temporary cash shortage and wealth destruction have affected in particular private consumption as fake currency and part of the illegal cash will not be redeemed. 

The shift towards a less cash economy and formalisation should, however, improve the financing of the economy

and availability of loans (as a result of the shift from cash to bank deposits) and should promote tax compliance, it says. 

The Organisation says private consumption in urban areas has been buoyed by prospects of higher public wages and pensions while government investment and consumption remained strong. The return to a normal monsoon in 2016, after two consecutive years of bad weather, is supporting a recovery in agricultural income and rural consumption. 

Despite the sustained public investment, total investment declined in real terms in the first half of 2016, it points out. 

The investment to GDP ratio has been on a downward trend for some years. Recently, low capacity utilisation and the weak financial position of some corporations have dampened corporate investment. 

Several factors have added to these cyclical factors. First, the banking system has been weakened by poorly performing public banks, which suffer from high non-performing loans.

Alternatives to bank funding, in particular, a corporate bond market, are underdeveloped in India, OECD points out. 

Second, infrastructure bottlenecks (e.g.frequent power outages) coupled with the often long land acquisition process, have held back investment, in particular in the manufacturing sector. Third, taxation is an issue, with relatively high corporate income tax rates combined with frequent and lengthy tax disputes, it says.

Overall, chronically low investment, were it to continue, would eventually result in weaker productivity and growth, the Organisation says.

However, it says private investment will pick up to some extent as excess capacity diminishes, deleveraging by corporates and banks continues and infrastructure projects mature. 

It says the implementation of the Goods and Service Tax (GST) from FY 2017-18 according to the government plan, will support investment and competitiveness over the medium-term even though it may have short-term adverse effects on inflation and consumption.

It warns that India faces risks, some of which are hard to quantify. Further structural reform is a clear upside risk for growth. Some states (including Maharashtra, Madhya Pradesh and Rajasthan) have taken the lead in reforming land and labour market regulations but it is still unclear whether others will follow up. 

There are also downside risks. Although the government is hopeful, rolling out the GST by April 2017 is an ambitious objective. Any slippage would risk delaying the investment recovery. 

The increase in public wages entails a risk for inflation, although this risk is limited given the small share of employees in the public administration in total employment (less than 2%) and the fact that implementation at the state level can be expected to be spread over some time. 

Risks to the banking sector remain elevated due to continuous deterioration in asset quality, low profitability and liquidity. Slower efforts to clean up banks’ balance sheets and recapitalise public banks would raise uncertainties and have bearing on investment. 

Some risks are interconnected. If the Reserve Bank of India increases interest rates to address the inflation risk, the sustainability of corporate debt could be affected, it warns. 

India is not immune to external shocks and vulnerabilities in the global economy. An increase in commodity prices could raise inflation, dampen private consumption and weigh on both the current account and fiscal deficit, the Organisation cautions. 

Pointing out that the new monetary policy framework and a more prudent policy stance have served India well so far, OECD says reaching the inflation target remains a challenge going forward, especially if public sector wage rises spill over to other sectors or if commodity prices rebound. 

Bringing down inflationary expectations further and establishing a solid nominal anchor to the Indian economy require

monetary policy to continue erring on the prudent side until inflation is arrested.  

It says since 2014 lending rates have adjusted only partially to the decline in policy rates, the  impact of monetary policy on real activity is reduced by weaknesses in the transmission mechanism, including administrative measures such as the requirement for banks to hold government bonds (SLR), credit quotas for priority sectors and caps on deposit rates. 

Several measures have recently been taken to improve monetary policy transmission including: the deregulation of interest rates offered on small saving schemes, incremental cuts in the SLR, the reduction in the daily cash reserve ratio that banks must keep with the central bank, and regulatory changes to force banks to rely more on the marginal cost of funding when calculating lending rates, the OECD report says. 

Despite liberalisation of foreign direct investment regime, restrictions on FDI were relatively stringent in 2016 compared to other BRIICS and OECD countries.