C16140 Sonal Varma

Sonal Varma, India Chief Economist, shares her outlook on India's economy after the Indian government's big decision to demonetize 500 and 1,000 rupee notes.  

The government’s decision to discontinue use of 500 and 1,000 rupee notes as legal tender has led to a lot of uncertainty on the potential short-run and longer-term ramifications for the economy. The government’s decision was motivated by the need to eliminate the black economy and curb financing of terrorism through fake currency notes.

India’s recent demonetization effort, unlike in 1946 and 1978, covers almost 86% of the total value of currency notes in circulation in India.  Hence, this is a substantially more widespread exercise that will have far-reaching implications.  It will cause short-term disruptions but will result in long-term benefits.

We see a risk that GDP growth could slow due to a cash shortage in the first few months due to the mismatch between demand (new notes for old) and supply (for new notes), however, this will be a transitory shock and should normalize by the second quarter of 2017. We expect wealth destruction, as fake currency and part of the illegal cash will not return, hurting conspicuous consumption demand and typical hoarding vehicles for black money (land, real estate, gold & jewelry). However, the rest of the economy will benefit over time and we expect GDP to grow in 2017.

The banking system will be the biggest beneficiary, in our view. As cash demand falls, we expect banks to garner higher incremental deposits, with some deployed in government securities. Higher levels of liquidity should mean lower deposit and lending rates.

Additionally, along with the impending move towards a goods and services tax next year, this will give a boost to formalization of the economy, which will increase tax compliance over time. We expect the demonetization effort to boost tax revenue by almost 0.6% of GDP, with bulk of the revenue gains to accrue next year. This will improve India’s fiscal health and also give the government an opportunity to spend more money on improving its public infrastructure.

Overall, the demonetization effort is a signal of the government’s ability to take short-term pain for long-term gain.

For deeper insights into each of these economic impacts, view the full report here.

Also seeIndia: Govt. cracks down on black money; de-monetizes high denomination notes’, November 9, 2016. In this note, we highlight the size of the shadow economy in India, the country’s past experience with demonetization and our assessment of the likely macro impact this time around.

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