The fight against black money, tax evasion and corruption led the Modi government to ban the two largest bank notes (Rs 500 and 1,000) in a surprise move as from 8 November. People have until the end of the year to exchange the notes for new ones or to put them on a bank account. However, weekly limits on withdrawals of new notes and a lack of newly equipped ATMs and money printing capacities are hitting hard consumer demand and cash-driven sectors such as agriculture, construction, retail trade and luxury goods which weigh for up to 1/3 of the GDP. It has resulted in a cash crunch and significant economic disruption as the measure was not properly prepared in a cash-based country where banned notes account for 85% of the value of currency in circulation.
Impact on country risk
Demonetisation is shock therapy for the fast-growing Indian economy which is now expected to decelerate by 1 or 2% in 2017. So far, the measure has been rather popular among many Modi voters who support the fight against black money and see Modi’s radical policy as a sign of his strong leadership. The timing of the badly prepared government decision might have been politically motivated by potentially undermining Modi’s cash-dependent regional opponents at key state elections in upcoming months. However, the cash shortage brings much public anger among the most hit, namely retail traders and farmers – albeit enjoying relaxed restrictions – in rural areas, and thus represents a risk for Modi’s next electoral hopes if the activity hindrance endures. Beside the noteworthy negative short-term economic impact which will notably depend on the (currently slow) speed of the new currency introduction, it remains to be seen to what extent demonetisation will reduce illicit money as much of it is invested in gold and properties. Moreover, the government’s latest decision to retain up to half of cash lastly deposited on bank accounts if the money was previously hidden from tax authorities might be a disincentive to bringing high-value notes to a bank account. The impact on banks, benefiting from boosted deposits and liquidity, might be negative in the short term as their lending activity is impeded by demonetisation issues (including costs). Another short-term consequence is the exacerbation of the downward spiral of inflation as money supply and domestic trade transactions are coming down, thereby paving the way for further interest rate cuts. In the long term, benefits might in theory materialise through a broader use of e-money, higher bank intermediation and bank deposits. In a country known for weak fiscal revenues and most of economic agents avoiding the fiscal radar, tax collection should increase thanks to an improved crackdown against tax evasion.
Analyst: Raphaël Cecchi, email@example.com