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India's Goods and Services Tax may disrupt economy in the short-term

India's historic approval of the Goods and Services Tax (GST) this week marked a milestone in Prime Minister Narendra Modi's two-year reign. Now comes the next step: Getting a handle on the move's economic impact.

"The GST is arguably one of India's most significant and ambitious reforms ever attempted," J.P. Morgan economists said in a note. By replacing a confusing mass of central, state, inter-state and local taxes—among the most common complaints of foreign businesses—the GST is widely expected to transform India into a common market, bringing with it increased efficiency and productivity.

But while the move is a game-changer for investor sentiment and paves the way for other structural reforms, strategists warn it could disrupt consumption and growth, at least in the short-term.

However, determining the exact economic impact hinges on the GST tax rate.

New Delhi has yet to agree on an exact rate, which has been flagged as a major hurdle to GST implementation. A panel led by the country's chief economic adviser Arvind Subramanian has recommended the standard GST rate to be 17-18 percent.

It's critical that lawmakers don't peg the GST rate too high as that may discourage the very compliance that the GST hopes to induce, J.P. Morgan explained.

As investors await details of the rate, here are some immediate implications from the latest development.

Gross domestic product (GDP)

"In terms of growth impact on [GST] implementation, we think the near-term could be messy, with adjustment costs for the private sector grappling with inter-sector implications, and the central government trying to compensate states for revenue loss," HSBC warned in a report.

If the GST rate is set at around the 17-18 percent mark, service producers would face an increased tax burden while manufacturers would see a fall, HSBC continued. That could cause manufacturers to not pass through benefits and service providers to pass on costs, moves that would lower consumption and overall growth, HSBC said. At present, the effective indirect tax rates on goods and services are 22.5 percent and 15 percent, respectively.

Over the medium-term however, the outlook is positive. HSBC believes GST could raise GDP by 0.8 percentage points while Goldman Sachs expects a 0-0.5 percentage point boost.

Inflation

"We believe that implementation of the GST in the near-term could bring some upturn in inflation; however, the impact should be transitory," according to a Morgan Stanley report.

A revenue-neutral rate (RNR) of 15 percent with a low rate of 12 percent and standard rate of 18 percent would have a negligible inflation impact, Morgan Stanley noted. But a higher RNR with a lower rate of 12 percent and a standard rate of 22 percent meanwhile, would have a 0.3-0.7 percentage point impact on aggregate inflation, it continued.

In HSBC's view, headline consumer price inflation (CPI) could rise by 0.2 percentage points if the GST rate is kept at 18 percent. If the rate is set at 22 percent, CPI could increase by 0.7 percentage points.

According to the most recent data, consumer prices climbed 5.77 percent on-year in June from a year, little changed from May's 5.76 percent increase.

Foreign exchange

"The passing of the GST will be welcome news for the Indian rupee (INR)," HSBC predicted.

So far, the currency has yet to see a GST boost. The rupee ended Wednesday weaker at 66.99 per dollar, snapping a six-day winning spree, and extended those losses in early Thursday trade.

But HSBC believes the GST will lead to higher foreign direct investment inflows and a narrow current account deficit-factors that should help the INR eventually outperform other Asian and emerging market currencies.

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