Demonetisation and GDP growth in fiscal year 2016-17: A presentation of three subjective scenarios

Today’s picture is not pretty: government needs to push up spending quickly and sizably to make up for a possible drop in the rest of the economy. This will ensure India's expected growth path is not disrupted in the short term.

Good buying opportunities for long term investors in the coming months in Indian stocks can be expected.

The demonetisation of Rs. 500 and Rs. 1000 rupee notes, which came into effect two weeks ago, is good for the economy and people in the long term, most Indians will agree. However, it can be argued that the implementation of this move has not been executed well.

Reports daily appear in the press and social media of the difficulties faced by people and businesses – both small and large – in conducting their daily activities both in large and small towns and across sectors.

I went yesterday to two ATM machines next to my residence, and found they dispensed only the new high value Rs. 2000 notes – which are not generally accepted at most shops for daily payments. A friend in Mumbai reported to me that she went to her bank – India’s leading private sector bank - to withdraw money, but was told that she could not withdraw money.

Rs. 500 and Rs. 1000 notes account for 85% of currency in circulation, and cash accounts for 11% of GDP in India. New notes on this massive scale need to be produced, distributed and stored in newly calibrated ATMs across India. The informal economy accounts for 40% of India’s economy, and mainly runs on cash.

Witnessing the execution of the demonetisation move, my own, clearly subjective, view is that it will take six months for cash to lubricate without friction the economy just as it did before.

I have created a picture (model) of the growth of India’s economy over FY16-17, and presented three subjective scenarios below.

Scenario 1

Informal economy shows zero growth in Q3 after demonetisation, but returns to its normal path in Q4 – The formal economy grows at 6.6% at a slower pace in Q3 after demonetisation and then returns to the normal growth path in Q4.

Net result: India’s economy grows by about 7% in 2016-17 – about 0.5% lower than expected.

Scenario 2

Informal economy shows negative growth of 5% in Q3 after demonetisation - and why not given all that I see and read in the papers - and recovers enough so that there is no fall in output in Q4 – The formal economy grows at 6.6% at a slower pace in Q3 after demonetisation, and then returns to the normal growth path in Q4.

Net result: India’s economy grows by about 6% in 2016-17 – about 1.5% lower than expected!

Scenario 3

Informal economy shows after demonetisation negative growth of 10% in Q3 and recovers enough so that there is no fall in output in Q4. The formal economy grows in Q3 at 6.6% at a slower pace after demonetisation, and then recovers, though not completely by rising to 7.2%, in Q4.

Net result: India’s economy grows by about 5.5% in 2016-17 – about 2% lower than expected!!

In this uncertain scenario, the 10% fall in India’s stock markets does not seem to be enough. Note this comes at a time when following a Trump victory in the USA interest rates are increasing – seen by many as just the beginning of a rising interest rate cycle. It looks like there will be good buying opportunities for long term investors in the coming months in Indian stocks.

My own view is that government needs to act fast and sizably to pump money into the economy – if that means a higher fiscal deficit then so be it. Government has already announced measures for the rural sector in the last week. RBI has asked banks to effectively extend the repayment period for loans by small businesses.

Inflation should trend lower. Deposit and lending rates have started coming come down. It is likely that RBI will reduce the key policy rate, the repo rate, at its next bimonthly monetary policy announcement in early December, unless the rupee comes under huge pressure.