• Initiatives implemented in India by Prime Minister Narendra Modi’s administration, such as the standard Goods and Services Tax (“GST”) and the note ban (“demonetization”), have been gradually forcing individuals and corporations to adjust to new ways of conducting economic activities.
• Consequences of these initiatives have been intended and unintended, positive and negative, with a particularly large impact on the labor market and informal sectors.
• It remains to be seen whether these initiatives will constitute a significant step forward in India’s quest to become a modern and globally competitive industrial economy.
• However, these reforms in conjunction with the banking sector recapitalization seem to address many aspects of much-needed changes to the India economy – namely efficiency improvements and a subsequent investment pick up.

More than a year after India hastily implemented its November 2016 note ban (also known as demonetization), the purpose and benefits remain much debated. The stated goal of demonetization was to broaden India’s tax base and strengthen the country’s economic foundation by removing “invisible money” from the monetary system. Most would agree that demonetization has had unintended consequences with a particularly large impact on the labor market. As an example, a number of real estate projects on the outskirts of India’s cities were halted as the cash needed to pay for materials and construction workers’ wages became scarce. Companies and workers were not prepared to immediately switch means of payment from cash transactions to bank services, such as online payments and wire transfers. Job losses occurred in labor-intensive and informal industries, such as construction, agriculture, textiles, and jewelry production, due to the lack of notes in circulation and the fact that certain denominations were banned and therefore had to be exchanged immediately. Most rural Indians (estimated at 67% of India’s population¹²) don’t have bank accounts or credit cards, so the lack of bills in the system has hit this portion of the population the hardest. The knock-on effects of the note ban are many, but perhaps the largest is that demonetization was a speed-breaker for the Indian economy, heavily impacting smaller companies accustomed to working almost exclusively in cash. While demonetization has been accepted by the population, possibly due to Modi’s popularity, more than a year on, the benefits of this bold surgical strike on black money remain elusive.

In contrast to the quick design and implementation of the note ban, it was after more than 17 years of efforts that the Indian government finally rolled out a unified tax collection system in mid-2017 – the Goods and Services Tax (“GST”). The intended impacts of the GST are to increase tax collections in the long run, simplify the tax code, and reduce the hidden costs of doing business in India. For example, under the previous tax regime, each state government had the power to set its own tax rate and these tax rates were only applicable for goods, not services. As a result, informal arrangements developed between states to take advantage of different tax rates and the lack of tax collection on services. Among the many problems of the previous tax regime were significant delays in inter-state logistics needed to comply with all the different state tax systems. While the GST implementation was not without its hiccups, GST was seemingly welcomed by most of the corporates with whom we met, as publicly listed entities tend to conduct business in the organized sector and have been paying taxes for years. Given the gap in GST compliance between the organized and unorganized sectors, some leading Indian companies are actively adjusting their strategies to harness market share gain opportunities and system level efficiency improvements. It could be the case that India implemented demonetization before GST because the reduction of the informal economy was crucial for a successful GST implementation. Furthermore, GST implementation alone cannot address the issues associated with India’s large informal economy. Though it is early to make a firm conclusion, GST collection seems to be under expectations so far, which questions the effectiveness of demonetization in expanding the tax base. Instead, after demonetization, a lot of system liquidity has flown into investment-focused financial products.

It remains to be seen whether demonetization and the GST will be the significant steps needed in India’s quest to become a modern and globally competitive industrial economy. Two companies we met with said that some of their smaller suppliers were not able to comply with GST, folding overnight and creating problematic delays in their product cycles. Another company we met with articulated concerns that the Modi administration will hastily implement additional such polices in the future, again disrupting its business. Having said that, these policies have already rendered some noteworthy implications for India’s economic participants. It will be an important milestone to see if small- and mid-sized companies seeking to become GST compliant will be able to bring a meaningful portion of workers into the formal sector and continue to prosper. Another factor long impacting India’s sustainable economic development is the lack of fixed asset investment, particularly in infrastructure. While the note ban and GST don’t directly address India’s infrastructure problem, removing “invisible money” from the system and reducing at least some of the “hidden costs” of doing business will hopefully channel funds to infrastructure projects in a more transparent and cost effective manner. On the heels of GST and demonetization, India announced a banking sector recapitalization in November of 2017. This was an important acknowledgement of the poor-quality assets on many state-run banks’ balance sheets. The efforts to address this problem could be an important jump start for fixed-asset investment against the backdrop of GST and demonetization.

We came back from our trip with confirmation that India’s economy is at a very interesting juncture of development. It is no coincidence these three harsh, but important, measures were implemented in a matter of one year. Whether these policies continue to be implemented uniformly – and how they interact with one another – will be critical to India’s long-term success.

The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.

Kate Jaquet is a Registered Representative of ALPS Distributors, Inc.

1. The World Bank, 2016.
2. Indian Bureau of Labor Statistics, Indian Labour Statistics, 2012-2013.