One year of demonetisation: Currency purge trips growth pace

Exact impact on growth difficult to estimate in absence of data on informal sector

“To break the grip of corruption and black money, we have decided that the Rs 500 and Rs 1,000 currency notes currently in use will no longer be legal tender from midnight tonight, that is November 8, 2016.”

Prime Minister Narendra Modi — November 8, 2016

It was a decision with few parallels in India’s economic history. On November 8, 2016, in an address to the nation, Prime Minister Narendra Modi announced the withdrawal of legal tender status to Rs 500 and Rs 1,000 notes.

In a country that transacts primarily in cash, this decision, which withdrew 86 per cent of the currency in circulation, caused widespread havoc, disrupting economic activity. 

It also effectively shattered hopes of a consumption-oriented recovery, which many economists had predicted would begin towards the second half (Q2) of FY17, thanks in part to a good monsoon and proceeds from the 7th Pay Commission. 

The headline growth numbers held up in Q3FY17, but dipped thereafter to 6.1 per cent in Q4FY17. Investments tanked, with gross fixed capital formation contracting 2.1 per cent in Q4. Excluding public spending and agriculture, gross value added (GVA) grew by a mere 3.8 per cent in Q4. But these numbers don’t reveal the true extent of the economic slowdown. 

“The quarterly gross domestic product (GDP) numbers are based largely on the formal sector data, and as such do not reveal the true extent of the slowdown in the informal economy, which was more badly hit,” says Pronab Sen, former chief statistician of India. But bank credit to micro, small and medium enterprises did contract and repayment rates of microfinance institutions slumped. 

Many feared that the cash crunch in the economy would badly sting India’s cash-intensive rural economy. 

And though subsequent data showed that sowing was better than in previous years, rabi production touched a high of 137.16 million tonnes in FY17, the events that unfolded in the months thereafter led many to argue that demonetisation had indeed broken the back of the rural economy. 

With household demand slowing down, it led to a crash in prices of commodities such as pulses, onion, vegetables, and oilseeds dropping well below their minimum support price. As a consequence, GVA by agriculture and allied activities grew by a mere 0.3 per cent (current prices) in Q1FY18.

“Demonetisation and its aftermath halted whatever little recovery the rural sector was witnessing after two back-to-back droughts of 2014 and 2015,” says Himanshu, associate professor, Jawaharlal Nehru University. 

“Prior to demonetisation, these sectors (rural non-farm sectors) were facing a stress, but 2016 onwards, things were getting better as the monsoon was good, but the benefits of a good monsoon were denied to the rural sector due to demonetisation. Further, rural wages, which had started showing a rising trend since July 2016, continued till January 2017, but after that they have slowed as the impact of demonetisation set in,” he adds.  Other experts concur. “Agriculture was badly hit and this had a knock-on effect on the non-agricultural unorganised sector, which, in turn, impacts the organised sector,” says Sen. “Also in the informal sector, financing typically flows from informal sources of credit. My sense is that demonetisation has broken those chains,” he adds. 

In the midst of all this, the Reserve Bank of India revealed that Rs 15.28 lakh crore of banned notes had been deposited back — dealing a big blow to expectations of lakhs of crores of black money not being returned into the system.

The unintended or perhaps the intended consequence of demonetisation was that it triggered a shift in household savings away from physical assets to financial assets. But on the other hand, the initial boost to digital transactions appears to have plateaued. 

While there was initial scepticism over the pace of remonetisation, once it gathered steam, economists expected the economy to bounce back in subsequent months. However, they were in for a rude shock.

As the deadline for shifting to the new indirect tax regime approached, companies cut back on production and resorted to destocking their inventory. As a result, GDP growth slumped to 5.7 per cent in Q1FY18, with manufacturing growing at a minuscule 1.2 per cent. 

So while demonetisation ended up hurting the cash-intensive informal economy more, the goods and services tax (GST) has ended up hurting the formal economy more, say experts.  

Some economists expect the economy to bounce back as the one-off effects of destocking reverse. 

A recent SBI research report pegs growth at 6-6.5 per cent in Q2FY18. But others are sceptical. There are two contrary forces that are operating in tandem right now. “One, the destocking we saw in Q1 is likely to reverse and companies will increase production and build up their inventories; and second, the disruptive effects of the GST on the formal economy,” says Sen. 

How these forces play out will determine whether growth will revive in the coming quarters or not.