Demonetization has potential to bring positive transformation
India's economy was slowing down in early FY17, until the favorable monsoon started lifting the economy, but the recovery was temporarily disrupted by the government's "demonetization" initiative.
On November 8, 2016, the government demonetized (i.e. removed legal tender status from) an estimated 23 billion INR 500 and INR1000 banknotes, corresponding to 86 percent of India's currency in circulation. Demonetization caused an immediate cash crunch, and activity in cash reliant sectors was affected. GDP growth slowed to 7.0 per cent year-on-year (y/y) during the third quarter of 2016-2017 from 7.3 percent in the first quarter.
As a result, a modest slowdown is expected in the GDP growth in FY 2016-2017 to 6.8 percent. According to the Update, growth is expected to recover in FY 2017-2018 to 7.2 percent and is projected to gradually increase to 7.7 percent in FY 2019-2020.
While limited data is available, demonetization may have had a disproportionate impact on poorer households, which are more likely to work in construction and informal retail. Demand for guaranteed employment up to February 2017 exceeded the full year of FY2015/2016 and rural consumption (in particular, sales of two-wheelers) contracted sharply in November. Greater data availability, especially on labour markets, is needed to better gauge the social impact of policies in the future.
Despite this, there was a relatively modest slowdown in the economy. The Update attributes it to coping mechanisms (which included greater usage of digital transactions), higher rural incomes, and robust public consumption. The pick-up in rural wages in November and December, and the growth of agricultural output suggests the positive impact of the monsoons substantially dampened the disruption from demonetization.
In the long-term, demonetization has the potential to accelerate the formalization of the economy, leading to higher tax collections, and greater digital financial inclusion provided measures such as increased use of property taxes is taken in the areas of tax policy and administration, and share of the population with access to the internet and digital means of payments are increased. The implementation of the GST could is a key complementary reform that will support formalization, as firms have a strong incentive to register with GST to obtain input tax credits, the Update adds.
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