‘Demonetisation will hurt GDP in the short run’

The impact of demonetisation on India’s GDP growth is clearly going to be negative in the short run but, on the positive side, it may improve the fiscal position, according to Fitch Ratings.

Thomas Rookmaaker, Director of Fitch’s Asia-Pacific Sovereigns Group, said the macroeconomic effects of the cash crunch due to demonetisation include a temporary delay in consumption and investment, disrupted supply chains, farmers being unable to buy inputs, and some loss in productivity due to time lost to deal with cash issues.

There are many elements to the demonetisation, which makes it difficult to quantify the impact on real GDP growth and explains the wide range of forecasts by different analysts, he added. Fitch assessed that the impact on GDP growth is clearly going to be negative in the short run and depends to a large extent on how long the cash crunch is going to last.

A significant decline in the growth number for this quarter is highly likely, but for the fiscal year as a whole the decline may still be relatively moderate.

No structural shift “People find inventive ways around the cash crunch as well — there is always the art of jugaad . At the same time, this seems to suggest that demonetisation is a one-off event and is not likely to generate a significant structural shift of activity from the informal to the formal sector,” said Rookmaaker.

Despite the demonetisation, Fitch expect India’s GDP growth to trend higher than China’s in the medium term.

In India, it expects GDP growth to accelerate in FY2018 on the back of reform implementation, monetary easing of the past year and infrastructure spending, while in China a continued increase in leverage in the broader economy is more and more becoming a burden for growth.

On the positive side, Fitch observed that the demonetisation may improve the fiscal position to the extent more earnings will be declared and a transfer is possible from the RBI to the government of the seigniorage earned from unchanged notes.

It said a stronger revenue intake would be positive from a rating perspective, as the fiscal position forms the Achilles’ heel in India’s sovereign credit profile, given the high general government debt burden and fiscal deficit compared with peers.

Further steps The rating agency said beyond the immediate policy issues of managing the cash crunch as best as possible and trying to mitigate the worst side-effects, it would be interesting to see what further steps the government will take to formalise the economy and structurally generate higher government revenues.

Moody’s Investors Service, in a report on demonetisation, said households and businesses will experience liquidity shortages, at least for a few months.

Moody’s take “There will also be a loss of wealth, as some individuals and companies will choose not to deposit funds into the formal financial system to avoid disclosing their sources.

“The move will weigh on GDP growth for a few quarters, dampening government revenues.

“Medium term, higher income declarations will boost tax revenues, and the government could receive a one-off transfer of the central bank's gain. This could support government capital expenditure and/or fiscal consolidation, which would be credit positive for the sovereign,” said Moody’s.

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