The International Monetary Fund (IMF) has projected India's growth to slow to 6.6 per cent in 2016-17 fiscal due to the strains that have emerged in the economy as a result of "temporary disruptions" caused by demonetisation.
However, demonetisation would have only short term impact on the economy and it would bounce back to its expected growth of more than eight per cent in the next few years, the IMF said.
The post-November 8, 2016 cash shortages and payment disruptions caused by the currency exchange initiative have undermined consumption and business activity, posing a new challenge to sustaining the growth momentum, the IMF said in its annual country report on India.
"Growth is projected to slow to 6.6 per cent in FY2016/17, then rebound to 7.2 per cent in FY2017/18, due to temporary disruptions, primarily to private consumption, caused by cash shortages," it said.
India's economy grew at 7.6 per cent in 2015-16. Tailwinds from a favorable monsoon, low oil prices and continued progress in resolving supply-side bottlenecks, as well as robust consumer confidence, will support near-term growth as cash shortages ease, the IMF said.
The investment recovery is expected to remain modest and uneven across sectors, as deleveraging takes place and industrial capacity utilization picks up, the report said.
In their report, the IMF Directors supported the Indian efforts to clamp down on illicit financial flows, but noted "the strains that have emerged" from the currency exchange initiative.
"They called for action to quickly restore the availability of cash to avoid further payment disruptions and encouraged prudent monitoring of the potential side-effects of the initiative on financial stability and growth," the report said.
Noting India's strong economic performance of the past few years, the IMF Executive Directors commended New Delhi for its strong policy actions, including continued fiscal consolidation and an anti-inflationary monetary policy, which have underpinned macroeconomic stability.
As such, the IMF recommended continued vigilance to potential domestic and external shocks and urged the authorities to further advance economic and structural reforms to address supply bottlenecks, raise potential output, create jobs, and ensure inclusive growth.
The IMF feels that on the external side, despite the reduced imbalances and strengthened reserve buffers, the impact from global financial market volatility could be disruptive, including from US monetary policy normalization or weaker-than-expected global growth.
"In the absence of disruptive global financial volatility, slower growth in China, Europe and the United States would have only modest adverse spillovers to India, given weak trade linkages," the IMF said.
"A key domestic risk stems from the government’s currency exchange initiative, where the near-term adverse economic impact of accompanying cash shortages remains difficult to gauge, while it may have a positive economic impact in the medium term," the report said.
Domestic risks also flow from a potential further deterioration of corporate and public bank balance sheets, as well as setbacks in the reform process, including in GST design and implementation, which could weigh on domestic demand-driven growth and undermine investor and consumer sentiment, it added.
"On the upside, larger than expected gains from GST and further structural reforms could lead to significantly stronger growth; while a sustained period of continued-low global energy prices would also be very beneficial to India," it said.
The IMF said progress on important economic and structural reforms over the last year has been impressive.
"Over the past year, big bang reforms, such as the legislation of a new bankruptcy code, formalisation of inflation targeting framework, and a milestone constitutional amendment enabling implementation of the pan-India Goods and Services Tax (GST), have taken place alongside continued steps implementing the gradualist reform agenda of the Bharatiya Janata Party (BJP)-led government of Prime Minister Narendra Modi," it said.
Notwithstanding its majority in the lower house of the national parliament, the BJP does not have control of the upper house, thus requiring consensus building for the passage of key legislation.
As a result, securing passage of the GST constitutional amendment spanned several parliamentary sessions and entailed compromise with regional parties, it said.
The Modi Government, it said, continues to work towards enhanced inclusive growth.
"The financial inclusion agenda has broadened over the past two years, evolving from providing greater access to bank accounts and financial services to introducing more
remunerative savings vehicles to diminish the luster of traditional gold-based savings," it said.
"The government's introduction of gold monetization schemes can boost financial intermediation by channeling domestic gold holdings to gold savings accounts, although uptake thus far has been minimal," it added.
GST adoption could raise India's GDP to over 8 per cent: IMF
The adoption of the GST could help raise India's medium-term GDP growth to over eight per cent and create a single national market for enhancing the efficiency of the movement of goods and services, the IMF said.
At the same time, the IMF also expressed concerns over the implementation of the Goods and Service Tax (GST).
"Although some uncertainties remain around the design and pace of implementation of the GST, its adoption is poised to help raise India's medium-term GDP growth to above 8 per cent as it will create a single national market and enhance the efficiency of intra-Indian movement of goods and services," the IMF said in its annual country report on India.
The IMF said larger than expected gains from the GST and further structural reforms could lead to significantly stronger growth, while a sustained period of continued low global energy prices would also be beneficial to India.
Noting that India's tax revenue-to-GDP ratio (at around 17 and a half per cent) remains considerably below than its emerging market peers, the IMF said the implementation of a robust GST should be a key priority given its growth-enhancing effects.
"The GST should have minimal exemptions, uniform cross-state rates, and as few tax rate tiers as possible," it said.
Key production inputs, such as energy and real estate, should be kept within the tax base to enable greater output gains and reduce the tax burden across sectors, the IMF said.
Rationalisation of the structure of direct taxes toward a lower corporate income tax rate with smaller and streamlined deductions and exemptions should continue, it said.
Efforts to improve tax administration should be stepped up as the scope for revenue gains is large.
According to the IMF report, Indian authorities were confident that the outstanding issues related to GST implementation could be settled promptly.
"The GST would provide for a significant improvement over the current indirect tax system. Tax reform priorities going forward include continuing the phased reduction of the corporate income tax rate from 30 to 25 per cent over four years, coupled with a simultaneous reduction in tax deductions," it said.
The GST replaces a plethora of cascading center, state, interstate and local taxes with a single, nationwide, value-added tax on goods and services.
IMF said the destination-based GST will create, for the first time, a single Indian market, and will greatly enhance India as an investment destination.
By subsuming most of the existing indirect taxes, such as excise, sales and services levies, the indirect tax structure of the country will become less complex and the cost of doing business will decline.
The Indian government expects to roll out GST by July 1 after it could not meet the April 1, 2016, target.
(With PTI inputs)