Former Prime Minister Manmohan Singh last week gave Parliament his estimate of how much India’s Gross Domestic Product growth will decline because of the effects of demonetisation. Withdrawing the Rs 500 and Rs 1,000 notes from circulation without immediately replacing them will cause a decline of 2% in this fiscal year’s GDP, said Singh, who has also been a former Reserve Bank of India governor and finance minister.

But Singh is also an Opposition politician, with no incentive to offer an optimistic view of that move that has become Prime Minister Narendra Modi’s signature initiative. For a less partisan view of the likely impact on India’s economy, we can look at the agencies whose job it is to predict these sorts of things.

Most ratings agencies are expecting the country’s growth forecast to be slashed by between 0.5 percentage points to 1 percentage point, with Ambit Capital projecting a much sharper decline, saying India’s GDP will only grow by 3.5% in fiscal year 2016-’17. That steep correction from Ambit has prompted accusations of bias, even though the firm has been incredibly optimistic about the Indian economy under Modi thus far.

Still, to put the estimates in context, India’s GDP grew at 7.6% in 2015-’16, with the Economic Survey expecting that figure to be between 7% and 7.75% for 2016-’17. Finance Minister Arun Jaitley was even hopeful of growth at the rate of 8.5% earlier this year. That number looks like a dream now, with no agency expecting the GDP growth to be over 7.4%.

Economic (in)activity

These changes come because of an expected drop in economic activity that both the agencies and the government will struggle to fully capture for some time now. The impact of withdrawing the high value notes, which covered 86% of all currency in circulation, has meant there is no cash in the market for people to transact with. This has affected small traders, led to a massive dip in production at medium-sized enterprises, reduced activity in the food mandis and forced migrant labourers to return home as factories temporarily shut.

The Centre for Monitoring Indian Economy, an independent think tank that has been cited by the Reserve Bank of India, has already put precise figures to its estimates of how much the economy is going to be hit.

The CMIE report said the overall cost will be Rs 1.28 lakh crore over the next 50 days as the economy deals with the liquidity shock. To put that into context, the nominal GDP grew by Rs 2.9 lakh during the October-December quarter in 2015. The CMIE spelled out the impact on various sectors

  • Rs 61,500 crore of business lost from reduced consumption
  • Rs 35,100 crore of cost borne by banks
  • Rs 15,000 in foregone wages during the period

This doesn’t include the effects that broken supply chains and the loss of consumer confidence might have on the economy, the CMIE said, even as liquidity returns to the system.

Worse, that liquidity – meaning being freely able to withdraw cash and transact normally, since right now withdrawals are restricted while the government struggles to print new notes – may not be coming any time soon.

A Credit Suisse research report has concluded that only Rs 1.5 lakh crore worth of new notes are back in circulation, compared to nearly Rs 14.18 lakh crore held in Rs 500 and Rs 1,000 notes that are now withdrawn. Worse, of the Rs 1.5 lakh that has returned to the system, most is in Rs 2,000 notes, that have limited transaction value, since few people can offer change for them.

According to ICICI Securities too, 64% of the value of the older notes will be back in circulation only by January 2017, and full normalcy is not expected till March next year. Although the government has not released numbers of how quickly it is printing new notes, the likelihood of liquidity being constrained for a few more months has been corroborated by Niti Aayog Vice-Chairman Arvind Panagariya, one of the government’s chief economists.

“In the short run, you have a liquidity crunch. It is going to impact economic activity and it is also happening. The problem is being gradually solved, liquidity is being put into the system back and at the pace at which we’re going, I imagine that might be maximum a quarter during which this shortage will stay.” 

— Arvind Panagariya

The hope, however, remains that the economy will rebound quickly afterwards, because of the pent-up demand in the system. But that presumes there will be enough confidence in the economy once it returns to normal for things to proceed as they did before, or even zoom forward, which considering the huge, cascading nature of this move is most likely impossible to predict.