The unanticipated shock of demonetization, making 86% of cash with the public illegal, is a massive disruption for the Indian economy. Following this, many reports and analyses have focused on its growth impact. A fairly common conclusion is the move will cause “short-term pain” but growth gains in the long term: In the short-run, consumption spending is particularly likely to be hit as also vast tracts of the cash-based productive segments. As the dust settles, and agents realign to higher levels of formal or recorded transactions, growth benefits will follow through a wider tax-base, better tax compliance, reduced transaction costs and enhanced efficiencies in various supply-chains; macroeconomic indicators are likely to improve too as inflation slows, fiscal balances improve and interest rates soften further on the ground.
The short-term effects are straightforward and real. Remember on the eve of this quarter, all but the private consumption driver of aggregate demand were non-existent. Private investment was showing no pickup, public capex was constrained, exports remained weak; private consumption too was dragged down by two successive drought years. In this configuration, growth expectations for the remaining half of 2016-17 depended on spending support from increased salaries of central government employees and robust rainfall effects on rural incomes.
The transitory but severe cash and credit crunch directly hurts consumption or 55% of demand, which is majorly transacted in cash; production segments where working capital and trade payments are cash-based; and incomes by destroying wealth (undisclosed as well as preferential cash holding of savings, etc.) and many daily-wage and short-term contract employees. Growth is expected to fall for two quarters from such effects, but this period is subject to how long the currency deficit endures; the latter could be quite long for remonetization is constrained by logistical rigidities in printing and distribution that are ill-equipped to match the scale and magnitude of withdrawal of currency with the public.
Can we be confident about a medium-term growth rebound thereafter? The state of the economy matters significantly here because that will primarily determine response capacities of each segment, sub-segment and interactions within to influence aggregate outcome. There is anxiety on this count. A look into the past few years reminds us that the slowdown in investments and exports is protracted, not new; use of manufacturing capacities has steadily been falling; non-performing and stressed asset levels are still on the rise, magnifying the balance sheet stress of large corporates and the banking system; deleveraging is progressing slowly, yet incomplete, while resolution of bad loans is proving difficult. GDP growth in the last two-three years has come off various stimuli – some from public capital spending support, but majorly from one-time, terms of trade gains that are now wearing off.
In this setting, demonetization could impose enduring costs via increased uncertainty, a possible risk-aversion as changes in spending behaviour of businesses and consumers become harder to predict; temporary strains upon already weak balance sheets could stretch out with further negative impact. Adjustment costs attached to any reform or shock responses are outweighed by expected future benefits when firms and banks are healthy, incomes growing, and demand prospects positive and certain. If we add global headwinds of political change and policy uncertainties to the domestic economic settings, it is hard to be sure that GDP growth will return robustly once normalcy is restored, i.e. it will not be hurt beyond the short-term.
Renu Kohli is a New Delhi based economist.