India's shock move to scrap 500 and 1,000 rupee notes has sent shockwaves through its cash-dominated economy.
On November 8 India Prime Minister, Narendra Modi announced that 500-rupee (A$10) and 1,000-rupee ($A20) notes would cease to be legal tender immediately.
People were told they could deposit or change their old notes in banks until December 30 and new 500 and 2,000 rupee notes would be issued.
The decision was taken to crack down on corruption and illegal cash holdings known as "black money".
In an attempt to curb tax evasion, the government expects to bring billions of dollars of unaccounted cash into the economy because the banned bills make up more than 80% of the currency in circulation. Some 90% of transactions in India are in cash.
According to Coface, a global leader in credit insurance and risk management, the one-off demonetization, if implemented with other sustainable measures, could have the following two key longer-term benefits:
1. Liquidity improvement for domestic banking system
Demonetization encourages cash-free transactions and (one-off, for now) deposits with the facilitation of new account opening for unbanked people, probably improving banks’ liquidity in the near term. However, some other incentives or measures to boost digital transactions, in addition to the ongoing banking reform, would be vital to move India to become a more long-term cash-free society, says Coface. This would help to enhance the transmission of policy rate changes to lending rates, thereby improving the effectiveness of the RBI’s monetary policy decision.
2. Increase in tax revenue
Most customer transactions (even for property and jewellery purchases) are settled in cash, so very few Indians (less than 5%) file tax returns. This one-off demonetization would somewhat help identify suspected cases for tax evasion and formulate a list of tax evaders, boosting the tax revenue and fiscal balance in the next financial year. The fiscal deficit target for the current financial year is 3.5% of GDP, in relative to the last financial year’s deficit of 3.9%. However, some other measures (such as better tax administration and tracing tax data) would have to be implemented for sustainable tax revenue in the longer term, which is crucial for funding public infrastructure projects and government spending.
In a special briefing Coface says the demonetization announcement has created huge shocks to Indian consumers.
“The arrangement for the over the counter exchange of the old notes has created some confusion, especially for those unbanked people and those living in rural areas possibly, triggering anger and political uncertainties for the upcoming state elections,” it says.
“The short-term ‘cash crunch’ amid the demonetization is generally believed to result in a slowdown in economic activity in India, ranging from a reduction of 0.5% to 2% of the GDP growth in the coming few quarters, negatively affecting all sectors.
Negatively affected sectors
“The most negatively affected sectors would be those using cash as major transactions and are linked more closely to the ‘black money’, so retail sector, specifically focusing on consumer discretionary items, jewellery and luxurious cars, and construction sector, mainly building materials segment, would probably be adversely impacted.”
Coface says on a positive note, the slowdown in economic activity would probably result in slowing consumer-price inflation, giving room for the RBI to cut its policy rates further which the policy repo rate stands currently at 6.25%.
However, the recent slump in Indian rupees against the US dollar amid the rate hike expectations of the US Federal Reserve might keep RBI cautious about near-term further easing.
“Even without any further easing, the improvement in domestic banks’ liquidity (mainly due to a boost in deposits amid the demonetization scheme) would probably help bring down the banks’ lending rates. This would probably reduce corporates’ overall borrowing costs in the coming few months,” Coface predicts.
Coface has a GDP forecast of 7.2% for India in 2016-17, with an A4 country risk assessment.