India: The pains and gains of demonetization Global Economic Outlook, Q1 2017

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​As demonetization hits India, affecting consumer demand and various industries, the question everyone is asking is how deep and long will this ripple be. In the long run, India may benefit immensely from the increased digitalization of the economy and expansion of the formal banking sector.


It might sound deceptive if one were to begin a report on India’s outlook by quoting the latest quarterly GDP growth. India grew at 7.3 percent year over year in Q2 FY 2016–17 and is among the fastest-growing economies of the world, and economic fundamentals are still very strong.1 However, recent events, specifically in the last quarter, have reshaped expectations and raised concerns about India’s future growth. International organizations such as Asian Development Bank as well as a few credit rating agencies and broking houses now expect growth to be slower than previously estimated by 30–350 basis points.2

Very rarely is an economy that grew at 7.2 percent in the first half of the fiscal year, and that still maintains strong economic fundamentals, expected to retreat from a robust growth path.3 The reason behind this setback in growth expectations is the government’s decision to demonetize over 85 percent of the currency in circulation overnight in order to curb the flow of unaccounted income, stop the flow of counterfeit currency (which is understood to fund illegal activities), push the economy toward a cashless digital system, and bring the unorganized and unbanked sector under the ambit of the formal economy. This government’s program is, in all likelihood, going to create a big ripple in the economy, where a significant proportion of transactions is conducted in cash, and over half of the population didn’t even have bank accounts before the demonetization move.4 The question that worries investors is how deep and long will this ripple be.

Very rarely is an economy that grew at 7.2 percent in the first half of the fiscal year, and that still maintains strong economic fundamentals, expected to retreat from a robust growth path.

In addition, global uncertainties have increased with Donald Trump’s win in the US election; the continued slowdown of the Chinese economy and the resulting financial turmoil; the steady rise in oil prices due to the Organization of Petroleum Exporting Countries’ (OPEC’s) decision to cut oil production volumes; and the fallout of Italy’s referendum to amend constitutional reforms (within a few months after Brexit), followed by the Italian government’s decision to recapitalize its oldest and most troubled bank. These events are likely to have significant long-term implications for India’s economic activity, trade, and its relations—affecting its overall path to prosperity.

At the time of writing this article, very few data were available to objectively assess the impact of demonetization on businesses and growth. The limited available data suggest that there are significant downside risks to economic activity in the second half of this fiscal year (FY 2016–17). However, the disruption to economic activity is expected to be temporary, as this demonetization initiative is not expected to destroy demand permanently but merely postpone it by a few months. As this article shows, economic activity is likely to bounce back, and growth may accelerate in FY 2017–18 on the back of strong fundamentals still in place, implementation of reforms, easing monetary policy and credit conditions, and infrastructure spending. More importantly, in the long run, India may benefit immensely from the increased digitalization of the economy and expansion of the formal banking sector.

Demonetization might disrupt economy in the short term

The unfolding effects of the withdrawal of the two highest-denomination bank notes (500 and 1,000 Indian rupees) since November 8, 2016, are not yet clear. However, there are two immediate channels through which demonetization may impact economic activity: the negative wealth effect shock and the liquidity squeeze. The negative wealth effect shock could happen if not all the old demonetized currency gets back to the system, affecting purchasing power in the long run and destroying demand permanently. The liquidity squeeze will likely be the result of a fall in the currency in circulation and the limited credit availability because of withdrawal limits, again restricting purchasing ability temporarily, which will be the case until credit constraints are removed.

The most obvious impact of these two would likely be on consumption, which has been the strongest pillar of growth, as households feel the cash crunch. At the same time, the possibility of any revival in long-term investment also plummets in the near term as businesses grapple with managing their supply chains while the economy remonetizes. This does not bode well for an economy whose growth has continued to remain lopsided, with consumption (both private and government) doing most of the heavy lifting. As per the latest data, investment growth continued to contract for the third quarter in a row.5

Contrary to expectations, the potential impact of the wealth effect shock has progressively declined, as 93 percent of the old notes have been deposited by the end of December 2016. (It is worth noting that, due to lack of data, it might be difficult to assess how much of the cash returned to the banks can be spent without scrutiny.) In other words, concerns over the negative effect of the unreturned money on demand in the long run have been mitigated. Consumers will likely come back with pent-up demand once currency circulation normalizes.

Concerns over the negative effect of the unreturned money on demand in the long run have been mitigated. Consumers will likely come back with pent-up demand once currency circulation normalizes.

Nevertheless, the impact of a liquidity squeeze has been widespread. To add perspective, the effective currency in circulation in the economy fell to 5.2 percent of GDP (as on December 23, 2016) from 11.3 percent of GDP before the demonetization (November 8, 2016).6 This squeeze in liquidity has left businesses, especially small and medium-scale enterprises, scrambling for cash to run their day-to-day operations, while lower workplace activity has impacted jobs. Unskilled and daily wage laborers have been the most affected as their employers fail to make payments on a daily basis.

According to a primary survey conducted by the State Bank of India (SBI) between December 30, 2016, and January 3, 2017, 69 percent of the respondents affirmed that their business was impacted because of the limited availability of cash; the construction sector and informal roadside vendors were among the worst affected.7 The performance management index (PMI) data released early in January reaffirmed that the cash crunch took a toll on the manufacturing sector, as it contracted sharply in the months post demonetization.8 Output and new orders fell in December for the first time in 2016, and companies reduced their purchases and payroll numbers substantially. At the same time, rising input costs (owing to supply chain disruptions and increasing oil prices) reduced profit margins for producers, as they failed to pass on the cost inflation to output charges, which rose at the slowest pace since August 2016.

Demonetization has also impacted consumer demand, as demonstrated by falling sales in the auto industry post demonetization. Both passenger car as well as two-wheeler segment sales reported the highest year-over-year decline since the Society of Indian Automobile Manufacturers (SIAM) started recording the data in 1997.9 As expected, house sales and new home launches took a substantial hit in the October–December quarter in eight major cities.

On the positive side, falling demand has resulted in declining prices across the board, indicating that the consumer price index may fall short of the Reserve Bank of India’s (RBI’s) 5.0 percent inflation target in March 2017. In addition, it is expected that some of the deposits in the form of old currency might attract tax and penalties and increase government revenues, thereby improving the fiscal balance.

An opportunity to transform India in the medium to long term

Undoubtedly, demonetization is likely to impact economic activity adversely, at least in the short term (two or three quarters), assuming the economy quickly remonetizes within the next couple of months.10 However, India can benefit substantially in the medium to long term if it optimally uses the opportunities this initiative may provide. At present, it might be hard to assess the implications, given the difficulty in evaluating costs and benefits associated with this move. However, expanding the formal economic grid and building a digital and cashless economy can go a long way in redefining India’s path to prosperity.

It is expected that rising deposits will increase liquidity in the banking system in the near term. This will likely help banks correct their balance sheets and increase their willingness to pass on the benefits of policy rate cuts to consumers by lowering lending rates. Again, suppressed demand and the liquidity squeeze might bring down inflation expectations, giving the RBI further room to cut policy rates. With concerns over the negative wealth effect shock waning and the increasing possibility of further monetary policy easing, demonetization may not destroy demand permanently but merely postpone it for a few months. In other words, once the liquidity issue is resolved, demand and production will surge back, compensating for the lost momentum.

In the long term, demonetization may encourage the economy to gradually move away from cash-based transactions to an electronic payment–based system. According to the SBI survey mentioned earlier, 15 percent of cash-based transactions (worth 250 billion rupees) have moved to digital transactions in the past two months.11 This may also accelerate the government’s initiative of financial inclusion by bringing more of the population into the formal financial net. With proper policies and a targeted approach, several small and marginal traders, merchants, and grocery shops could be brought into the formal economy through digital platforms.

With proper policies and a targeted approach, several small and marginal traders, merchants, and grocery shops could be brought into the formal economy through digital platforms.

The corporate sector may benefit in the long run as well. The financial (especially banks) and telecom sectors have immense potential to grow and innovate as more people (especially from rural India) come into the formal financial system. Rising digitalization may provide the information technology (IT) and IT enabling services (ITES) industries greater opportunity to develop software that enables digital transactions and to expand services for the masses.

Sectors that are highly dependent on cash transactions, such as manufacturing and construction, will likely be hit. The manufacturing sector has been struggling to grow at a steady pace on and off since 2011. With demonetization and the ensuing cash crunch, this sector’s revival might be pushed further away. However, manufacturing and mining are also the sectors where the majority of businesses do not fall under the formal economic grid. Forcing these businesses to operate in the formal economy is surely desirable, even though it might imply that these sectors may have to go through a prolonged and painful transition, as unviable units close and low-skilled and daily wage jobs are lost.

There might be some corrections in real estate prices, too, which is already evident in some of the big cities. However, real estate prices were due for correction for some time now, particularly in the repurchase market; a correction in prices will likely have a disinflationary impact and make homes affordable for taxpayers.

Sectors that will be impacted by demonetization


  • E-commerce
  • Banking industries
  • Financial technology
  • ITES


  • Agriculture
  • Luxury goods (SUVs, gems, jewelry, etc.)
  • Real estate
  • Commodities
  • Traditional retail (roadside vendors, cab drivers, etc.)

Global uncertainties pose risks

Beyond demonetization, a few global events are likely to have a significant impact on India’s economy in the coming quarters: the outcome of the US election, rising global oil prices, and the heightened global uncertainty resulting from China’s slowdown and geopolitical and financial tensions in Europe.

Donald Trump’s win in the US presidential elections is of great significance due to possible policy changes on a number of fronts, and it has the potential to impact the global economy considerably. Expectations that the new administration might increase government spending (through infrastructure outlay) have resulted in considerable optimism in the US equity and bond markets. However, the US president has also hinted at the possibility of stricter US trade policies, where he has the authority to act independently. A stricter trade regime may impact India’s exports to the United States, as well as cross-border capital movement. That said, these are all speculations, and it will take a few months to get clarity about Trump’s policy direction.

In November, OPEC struck a long-sought agreement to reduce production by 1.2 million barrels a day.12 If the member countries stick to this agreement, which they have been doing so far, a cap on production will likely reduce the supply glut that has depressed oil prices for over two years. Gradually rising oil prices are likely to impact the trade deficit of India, which is a net importer of crude oil.

The impact of the Brexit issue has been muted so far, as expected. However, Euroscepticism is on the rise, which is evident from the fallout of Italy’s referendum and the increasing criticism of strict austerity policies imposed by the European Union throughout large parts of the continent. Many European nations are witnessing the rising influence of nationalist and far-right parties as well as anti-globalization sentiments. In addition, the Italian government’s bailout of the country’s banks and the financial trouble within China have unnerved global investors. Consequently, emerging economies are witnessing strong capital outflows, while the US dollar has appreciated substantially in the past few months.

India, too, has witnessed a strong portfolio investment outflow since October, while foreign direct investment inflows have softened. That said, India’s good relations with Trump in the past, a stronger dollar, and strong demand for software developers and professional services in the United States will likely help India’s IT and ITES industries grow at a sustainable pace.

Overall, as events unfold, several forces will continue to reshape growth expectations in the coming months. The impact of demonetization is likely to be more transient than what the market anticipates, with substantial potential benefits in the long run. However, these depend on the government’s next attempts to contain the pain and tap into potential gains. Global uncertainties may accelerate capital outflows. However, strong fundamentals and reform implementations, together with easing inflation and monetary policy, will likely keep inflows of direct investments and business sentiments steady. The likelihood of continued appreciation of the US dollar against the Indian rupee will help increase revenues and the competitiveness of India’s export-oriented businesses.