Singapore: Ridham Desai, managing director, Morgan Stanley India, who also serves as head of India equity research and India equity strategist, spoke in an interview about the impact of demonetization on India’s economic growth, the challenges in implementing it and the roll-out of the goods and services tax (GST).

Desai said estimates of unaccounted money lying in cash may be an exaggeration. “To me, a lot of India’s unaccounted income sits in assets, and cash is largely in trade and used for transactions. It is not used to store unaccounted money—it is not a store of value," he said.

Edited excerpts:

Do you think the demonetization process will see the Reserve Bank of India (RBI) take currency that is not surrendered during the process as a profit and pass this on to the centre? If they were to do that—and assuming that about 25% of the Rs500 and Rs1,000 currency notes in circulation does not come back—then it is windfall gain of about Rs3.5 trillion.

This is still in the realm of speculation, and people seem to getting overly optimistic about the process. We’ll take it step-by-step. The numbers you have quoted is your estimate—we don’t really even know what the numbers will be. There is no science behind the numbers that are being quoted, and we should wait for the dust to settle to see exactly where we are, and what RBI does, rather than second guess. Right now, there is an execution challenge—there is $220 billion cash that has to be replaced in the system, and that is not easy. I would not jump to any conclusions, and also to my mind, the sums involved are not that large. To me, a lot of India’s unaccounted income sits in assets, and cash is largely in trade and used for transactions. It is not used to store unaccounted money—it is not a store of value. I think you are overestimating the amount of black money that is circulating as cash. It is more likely that the black money that India has accumulated over the years is sitting in assets like property and gold.

Will demonetization impact growth?

There are two steps here. This is part of a series of steps the government has taken to arrest the creation of black money—and as the prime minister has said, more steps are coming. So, it will go a long way in cleaning up India and making corruption more difficult, and will be a boost to long-term growth. This will bring about formalization of the Indian economy. The near-term impact is likely to be negative as India is a very cash-intensive economy—about 12-13% of India’s GDP (gross domestic product) is cash, and it has not gone as electronic as it ought to and, maybe, this move will force more electronic transactions. Therefore, it is a step in the right direction, despite the negative near-term impact. Replacing $220 billion in cash is not an overnight affair.

Will demonetization impact the Bharatiya Janata Party’s (BJP) prospects in the coming state elections?

It is important to have the public of the country to support you when you are doing such an activity where a lot of people are put through pain. So far, it seems like there is still a lot of support for this move. The population thinks India is doing the right thing by hurting the small class of people who do not pay taxes and deal with unaccounted money. There is some impact on people’s daily lives, but this is good for the long-term. I think the government has ground support from the people on this, and from that perspective, there should not be any major impact on the coming state elections for the BJP. It is possible that some political parties may be hurt because they have cash dealings, while other political parties that have lesser cash dealings may benefit, but this is a separate debate altogether.

The execution challenges that demonetization faces—will this have any impact on the roll-out of the GST, although both issues are not related?

GST is another step that will help eradicate black money. It is a bigger step than demonetization. Its impact on the economy is much wider than demonetization, and its effectiveness in bringing down unaccounted transactions is far larger—these are all steps in the same direction, but they are not inter-related, and demonetization won’t have an impact on the roll-out of GST.

On the GST deadline, it is a tough one, and there could be delays. There are 33 pieces of legislation to be passed, there is a massive execution roll-out—let us not underestimate the size of the task at hand. This is the biggest tax change in the world, ever. We are talking about nearly 10 million firms, 30 million digital signatures, and about 3.5 billion transactions annually—these are not small numbers by any stretch of imagination. If the government achieves the 1 April deadline, it will be fantastic, and to my mind, a very positive surprise.

Why has the investment cycle not picked up?

Last year, I had said it will pick up in 12–18 months, and it looks like it is still another 12 months away. It has not picked up on the private side. On the government side, infrastructure spending has picked up quite a lot. The private side is impeded because there is a lot of debt on the balance sheet and capacity utilization is still low. Growth pick-up has been slow because of the drag from exports— now that drag is going away. Keeping aside the short-term impact from demonetization, over the course of the next 12 months, there will be signs of recovery in private capital.

Looking back at the Narendra Modi government’s tenure so far and looking forward to the next two-and-a-half years, how do you see it playing out? Will the remaining tenure be more about execution, rather than new reforms?

Reforms is largely execution. It is not about tax law changes. A lot of investors mistook reforms to be about major changes in laws—but it is a much broader thing. It is about changing the way business is done in India. It is about changing mindset, it is making the system cleaner, it is about setting in place processes which are difficult to manipulate—these steps are all happening and they will continue to happen over the remaining two-and-a-half years of the Modi government, too. The reason why these steps have not resulted in better growth thus far is because the world has not been supportive. If you look at it, last year, global trade collapsed, and this was not there in anyone’s forecast. India cannot be immune to these developments as it is the eighth largest economy. Otherwise, growth would have been better on the steps that this government has taken.

This government has completely altered the execution of infrastructure—we are building infrastructure at a scale that we have never seen before, whether it be roads, railways—we are seeing a massive scale-up in execution. They have amended tax laws and we are on our way to GST. Third is fiscal consolidation—there is serious fiscal consolidation that has happened in the last two-and-a-half years, and India’s deficit is at a low point. Primary deficit is at a multi-year low. Save for 2007, we are heading for our lowest primary deficit ever, and who knows, in the next couple of years, India could even head into primary surplus. So, these are big changes that have happened, but they have not caught the headlines—but it reflects the changes in the Indian economy. Real rates are positive, there is a big shift in savings, the current account deficit has fallen and the ratio of FDI (foreign direct investment) to FPI (foreign portfolio investment) has turned on its head. Earlier, FPI used to be 80% of India’s capital flows, but today, FDI is 80%3so there is a very big shift that has happened, and this is a consequence of all the actions of the government, and also helped by India’s long-term structural story. All these things have come together. So, changes in the past two-and-a-half years have been significant, and we will continue to see changes.

You had pointed out that global trade had collapsed last year. With protectionist sentiment intensifying, will the slowdown or stagnation in global trade become the norm—more of a permanent phenomenon, rather than a one-off year?

I am not an expert on this, but it is possible; and, even then, it won’t be a precipitous 20% fall that we saw last year. If it stagnates, it is still okay when compared to a 20% fall. Its incremental impact will be as negative as it has been in the last 12 to 18 months.

How worried are you about China?

China has got a problem in terms of leverage on its balance sheet. We think that it will get fixed over time, but it won’t be a quick fix. That drag is there on global growth, which is why global growth, for other reasons as well, will not be going back to 5% that we saw in the past decade. We are living in an environment where growth is more tepid then before. China is one of the factors, but there are other issues as well, such as demographic issues in Europe and Japan. It is a combination of several factors that have come together to slow down growth.

How do you see Donald Trump’s presidency impacting India?

There are fears in the market about visas, but it is still early days. We have not seen any policy announcements from Trump’s side. We are yet to see key appointments. My norm for assessing what governments will do is to not use what was said in the campaigns. Running a campaign is different from running a government. The current speculation is based on the campaign that he ran. What Trump does in government has to be seen when he actually takes office. My generic view is that it is not good for the US economy to retract on outsourcing to India, because that (outsourcing) actually helps American companies and gives them access to cheap skilled labour.

What are the sectors you are bullish on?

We took some money off the table in September on banks and on consumer discretionary stocks because we thought the market had become frothy. I would say private banks should do very well and select NBFCs (non-banking financial companies) should also do well—discretionary consumer should also do very well. The market is in a correction zone, and this should continue for a little while, and as the froth ends, the moment to buy will come. I think technology also looks very attractive on a valuation basis—it has got a little bit slammed for various reasons. We also like industrials because of the recovery in government capex. What we don’t like is consumer staples—they look rich, and I am still hesitant to buy healthcare as the local earnings over there is uncertain—we are underweight on telecoms because of the competitive pressures. We are underweight on pharma because the valuations remain a little bit frothy, but the adjustments are happening.

But are Indian IT companies equipped to face disruption?

The sector is now discounting very low EPS (earnings per share) growth for the next few years—the number has slipped into just about mid-single digit levels. The stock market is just not about what the sector will do—we also have to access what is priced in. Given what is priced in, the risk-reward is in favour of being overweight on the sector. I don’t want to be drawn into a debate on what the sector will do, because the pricing is attractive.

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