Demand-supply shock debate divides economists

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Economic activity was disrupted in the past year due to demonetisation and the goods and services tax (GST). But the jury is still out on how the two shocks affected the economy.

Was demonetisation a demand-side shock to the system or were both supply-side shocks? If the latter holds true, is a consumption-oriented fiscal stimulus the appropriate policy response? Questions such as these continue to bother economists.

The November 2016 decision to demonetise Rs 500 and Rs 1,000 notes effectively withdrew 86 per cent of the currency in circulation. This was a demand-side shock to the economy, and dealt a severe blow to hopes of a consumption-oriented recovery. Private consumption held up initially, growing at 11.1 per cent in Q3FY17, but subsequently slid to 7.3 per cent in Q4FY17.

But some experts contend that demonetisation wasn’t only a demand-side shock to the system.

Pronab Sen, former chief statistician, says: “By virtually killing of credit from informal sources of finance, demonetisation was both a supply- and demand-side shock for the informal sector. For the corporate sector, though, it was a demand-side shock.”

Madan Sabnavis, chief economist at CARE, says: “While demonetisation was a demand shock, it was a supply shock for the MSMEs (micro, small and medium enterprises).”

Some economists have argued the rise in imports during this period can be attributed to a fall in production due to the disruption caused by demonetisation to domestic supply chains. Data show non-oil non-gold imports grew 6.3 per cent in Q3FY17, rising to 9.7 per cent in Q4.

But the demonetisation-induced demand shock to the system should have dissipated as remonetisation gathered steam. Reserve Bank of India (RBI) data show currency with public picked up from Rs 12.6 lakh crore at the end of Q4FY17 to Rs 14.9 lakh crore at the end of Q2FY18. But private consumption growth slid to 6.7 per cent in Q1FY18 and further to 6.5 per cent in Q2FY18.

What explains this? 

During this period, the economy faced another disruption — the GST. In Q1FY18, companies cut production and de-stocked inventories. Manufacturing growth plunged to a mere 1.2 per cent in Q1FY18.

GST is a supply-side shock for corporate as well as the informal sector,” says Sen. “It has also caused massive disruption in trade.”

The GDP data show trade, hotels and transport grew at 9.9 per cent in Q2FY18, down from 11.1 per cent in Q1. Further non-oil non-gold imports grew 26 per cent in Q1FY18 and 17.3 per cent in Q2FY18, suggesting that higher imports helped replace the production disruptions in domestic supply chains.

Now, experts say these twin supply-side shocks have affected demand via employment. Companies, especially the MSMEs, cut production; employment fell; this reduced aggregate demand, offsetting the push to demand from remonetisation.

“To the extent that demonetisation restricted household demand, remonetisation would have reduced the demand shock,” says Sabnavis. “But the supply-side disruptions due to demonetisation, and aggravated by the GST, would have reduced employment and lowered demand, that is unlikely to have come back.”

Another way to see the persisting demand shock to the system is to look at GDP deflator. 

“The deflator for this segment (trade, hotels, transport and communication services) has been declining for three quarters (from 5.0 per cent to 2.1 per cent), which is contributing to higher real growth,” says Soumya Kanti Ghosh, group chief economic advisor at State Bank of India. “This is also the case for the financing, insurance, real estate & professional services sectors, where deflator has declined from 7.3 per cent in Q4 FY17 to 2.6 per cent in Q2 FY18. This indicates demand is still a laggard in the system.”

So, in this situation, what is the appropriate policy response?

While some argue the government desist from any kind of stimulus, others argue in favour of it. 

“Countercyclical policy might just be the required medicine,” says Ghosh, on account of the low level of demand in the system.

“The government’s response should be to boost employment in the informal sector,” says Sen. “The focus should be on programmes such as rural roads, housing, minor irrigation projects which encourage labour intensive work.”

Sabnavis says a fiscal stimulus is a short-term measure to boost growth. “Will have to wait for the economy to adjust to a new equilibrium,” he adds.