Indian Prime Minister Narendra Modi’s surprise move to recall rupee bills of 500 ($7.3) and 1000 denominations has thrown into turmoil the $2n-plus economy in which cash transactions account for a huge 90% of the total. The “masterstroke” was targeted at the deep-rooted problem of “black money” as well as the rampant usage of counterfeits to fund terrorist activities, which together account for 20% to 25%, or up to $500bn, of the economy, according to various estimates.
Economists say the move will be beneficial in the long run as it is targeted at weeding out tax evasion and corruption. But a badly executed bold move is now threatening to weigh on India’s world-beating growth and corporate recovery, pushing Asia’s third-largest economy into a liquidity crisis.
Consumer spending makes up nearly 60% of India’s economy. With about 86% of currency in circulation no longer legal tenders and a small stock of smaller denomination notes available amid a seemingly never-ending struggle to get hold of new bills, consumers are holding back.
Finance Minister Arun Jaitley said on November 9 the move will damp consumption in the short term. Credit Suisse estimates more than 90% of consumer purchases in India are made in cash as more than 65% of Indians don’t have bank accounts. Even more are without bank cards and infrastructure for online transactions is poor.
Corporate operating profits are now tipped to fall by as much as 40% in the current quarter.
The economic impact will be profound. India’s gross domestic product, which grew 7.6% last financial year, dropped to 7.1% in the quarter ending June 2016. In the year to March 2017, the cash crunch is estimated to pull down GDP growth from last year’s 7.6% by as much as 5 percentage points. Brokerage Ambit Capital does not rule out a contraction in the October-December quarter.
The vast services sector, which accounts for two-thirds of GDP, is worst hit.
Worse, the situation is not going to improve anytime soon despite Modi’s “ignore-the-temporary-hardship” plea, asking for a 50-day period from November 8 to put the house back in order.
Here is why: India’s federal administration may need until May 2017 to replenish the stock of now worthless bills, says Saumitra Chaudhuri, the economist who advised Modi’s predecessor, based on extrapolation from central bank data and India’s maximum currency printing capacity.
The demonetisation step, however, will have a significant impact on financial inclusion and could trigger an interest-rate reduction, according to experts. Slowing inflation allowed a panel led by Reserve Bank of India governor Urjit Patel to lower the benchmark rate to the lowest in more than five years last month. A further reduction would help revive stalled infrastructure projects, say analysts.
Modi’s stated intent to take on India’s crippling cancer of unaccounted money with a “surgical strike” has never been questioned, but his carpet bombing strategy (amid allegations of exclusive “leaks”) that has left millions of ordinary Indians scrambling to secure their hard-earned legitimate money leaves a number of questions unanswered.