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GDP growth in 2017-18 is projected at 6 ¾ to 7 ½ percent Post-demonetisation

New Delhi: January 31,2017

The Government says that the adverse impact of demonetisation on GDP growth will be transitional. The Economic Survey 2017 presented in Parliament today by 
 the union Finance Minister,  Shri Arun Jaitley states that once the cash supply is replenished, which is likely to be achieved by end March 2017, the economy would revert to the normal.  Therefore the real GDP growth in 2017-18 is projected to be in the range of 6¾-7½ percent.

The Economic Survey points out that demonetisation will have both short-term costs and long-term benefits as detailed in the attached table. Briefly, the costs include a contraction in cash money supply and subsequent, albeit temporary, slowdown in GDP growth; and benefits include increased digitalization, greater tax compliance and a reduction in real estate prices, which could increase long-run tax revenue collections and GDP growth.

On the benefits side, early evidence suggests that digitalization has increased since demonetisation. On the cost side, effective cash in circulation fell sharply although by much less than commonly believed – a peak of 35 percent in December, rather than 62 percent in November since many of the old high denomination notes continued to be used for transactions in the weeks after 8th November  Additionally, remonetisation will ensure that the cash squeeze is eliminated by April 2017. The cash squeeze in the meantime will have significant implications for GDP, reducing 2016-17 growth by ¼ to ½ percentage points compared to the baseline of 7 percent. Recorded GDP will understate impact on informal sector because, for example, informal manufacturing is estimated using formal sector indicators (Index of Industrial Production). These contractionary effects will dissipate by year-end when currency in circulation should once again be in line with estimated demand, which would also allow growth to converge to a trend by FY 2017-18.

The Economic Survey states that the weighted average price of real estate in eight major cities which was already on a declining trend fell further after November 8, 2016 with the announcement of demonetization. It goes on to add that an equilibrium reduction in real estate prices is desirable as it will lead to affordable housing for the middle class and facilitate labour mobility across India currently impeded by high and unaffordable rents.

The Survey suggests a few measures to maximize long-term benefits and minimize short-term costs. One, fast remonetisation and especially, free convertibility of cash to deposits including through early elimination of withdrawal limits. This would reduce the GDP growth deceleration and cash hoarding. Two, continued impetus to digitalization while ensuring that this transition is gradual, inclusive, based on incentives rather than controls and appropriately balancing the costs and benefits of cash versus digitalization. Three, following up demonetisation by bringing land and real estate into the GST. Four, reducing tax rates and stamp duties. And finally, an improved tax system could promote greater income declaration and dispel fears of over-zealous tax administration.

 

Impact of Demonetisation

Sector

Impact

 

Effect through end-December

Likely longer-term effect

Money/interest rates

Cash declined sharply

Cash will recover but settle at a lower level

 

Bank deposits increased sharply

Deposits will decline, but probably settle at a slightly higher level

 

RBI's balance sheet largely unchanged: return of currency reduced the central bank’s cash liabilities but increased its deposit liabilities to commercial banks

RBI's balance sheet will shrink, after the deadline for redeeming outstanding notes

 

Interest rates on deposits, loans, and government securities declined; implicit rate on cash increased

Loan rates could fall further, if much of the deposit increase proves durable

Financial System Savings

Increased

Increase, to the extent that the cash-deposit ratio falls permanently

Corruption (underlying illicit activities)

 

Could decline, if incentives for compliance improve

Unaccounted income/black money (underlying activity may or may not be illicit)

Stock of black money fell, as some holders came into the tax net

Formalization should reduce the flow of unaccounted income

Private Wealth

Private sector wealth declined, since some high denomination notes were not returned and real estate prices fell

Wealth could fall further, if real estate prices continue to decline

 

Public Sector Wealth

No effect.

Government/RBI's wealth will increase when unreturned cash is extinguished, reducing liabilities

Formalization/

digitilisation

Digital transactions amongst new users (RuPay/ AEPS) increased sharply; existing users’ transactions increased in line with historical trend

Some return to cash as supply normalises, but the now-launched digital revolution will continue

Real estate

Prices declined, as wealth fell while cash shortages impeded transactions

Prices could fall further as investing undeclared income in real estate becomes more difficult;  but tax component could rise, especially if GST imposed on real estate

Broader economy

Job losses, decline in farm incomes, social disruption, especially in cash-intensive sectors

Should gradually stabilize as the economy is remonetized

GDP

Growth slowed, as demonetisation reduced demand (cash, private wealth), supply (reduced liquidity and working capital, and disrupted supply chains), and increased uncertainty

Could be beneficial in the long run if formalization increases and corruption falls

 

Cash-intensive sectors (agriculture, real estate, jewellery) were affected more.

Recorded GDP will understate impact on informal sector because informal manufacturing is estimated using formal sector indicators (Index of Industrial Production).

But over time as the economy becomes more formalized the underestimation will decline.

Recorded GDP will also be overstated because banking sector value added is based (inter alia) on deposits which have surged temporarily

Informal output could decline but recorded GDP would increase as the economy becomes more formalized

Tax collection

Income taxes rose because of increased disclosure

Payments to local bodies and discoms increased because demonetised notes remained legal tender for tax payments/clearances of arrears

Indirect and corporate taxes could decline, to the extent growth slows

Over long run, taxes should increase as formalization expands and compliance improves

Uncertainty/

Credibility

Uncertainty increased, as firms and households were unsure of the economic impact and implications for future policy

Investment decisions and durable goods purchases postponed

Credibility will be strengthened if demonetisation is accompanied by complementary measures. Early and full remonetisation essential. Tax arbitrariness and harassment could attenuate credibility

 

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