De-legalisation of Currency Erases INR1.5trn from FY17 GDP, Growth to Fall to 3-Year Low

India Ratings and Research (Ind-Ra) has revised its gross domestic product (GDP) growth forecast for FY17 to 6.8%, 100bp lower than its earlier projection of 7.8% (FY16: 7.6%, FY15: 7.2%). The downward revision is a fallout of the disruption caused at various levels in the economy due to the de-legalisation of banknotes of INR500 and INR1,000 denominations from midnight of 8 November 2016. Ind-Ra's analysis shows that the economic cost of the de-legalisation will be INR1.5trn for FY17.

While there are no two opinions about the need to root out black income, Ind-Ra's analysis shows that at best the current measures are likely to destroy INR4.004trn worth of cash held in black money and fake currency. This constitutes a mere 12% of the black economy in India, leaving 88% of the black money to remain in the system. Global experience, including that of India in the past has shown that the impact of such measures have been fairly short-lived (India followed the de-legalisation route twice in the past, firstly in 1946 and then 1978) as it does not attack/plug the mechanism that gives rise to black income.

On the demand side, the GDP component that would be the worst hit is investment. Investment, particularly private investment, which is already down and out due to various reasons, will face the brunt of the de-legalisation. Ind-Ra now expects gross fixed capital formation (GFCF) for FY17 to grow at 2.0%, down 306bp from our earlier projection. With the decline in cash holdings in the hands of the people and severe restriction in the flow of new cash, consumption demand has also fallen impacting both wholesale and retail sales. Anecdotal evidence suggests that the cash squeeze has reduced sales in the informal sector by 30%-40% during the first fortnight following the de-legalisation. Therefore, Ind-Ra expects private final consumption expenditure (PFCE) to grow at 7.5% in FY17, 89bp lower than our earlier projection.

However, Ind-Ra believes, despite disruptions, there are positive spin-offs for the economy from the de-legalisation of the high value currency. Ind-Ra believes de-legalisation, coupled with the government's resolve to promote the digital platform for transactions will gradually increase the share of the formal sector and expand the tax base of the economy in the medium-to long-term. Also, as transactions through the digital platform increase, it will create financial and transactional history of the informal/cash dependent segment, making them 'bankable' over the medium-to long-term.

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