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The very first measure of the impact of demonetisation on economic activity has appeared. November’s PMIs or Purchasing Managers’ indices show that manufacturing slowed down whereas the services segment sank into negative territory. The former held above 50, the bar between expansion and contraction, dropping to 52.3 (2.1 point fall over October). But business activity in services plunged to 46.7, which is a 7.8 point drop in a month. And that in just about 20 days of liquidity crunch in a cash-dependent sector, which forms 60% of India’s aggregate output. Not surprising then that overall private sector activity, captured by the Composite PMI Output index, was dragged down into contraction zone to 49.1 last month.

However, as most anticipated this ‘short-term pain’, evidence to the effect shouldn’t be such a surprise. Neither should be its sectoral distribution, because close to about 45% of services fall into the unorganized domain where transactions tend to be cash-based. So a shortage or absence of the key medium of exchange would expectedly squeeze operations in trade, transport, hotels & restaurants, repairs-renting businesses, real estate, and construction, which are the main categories. Newspaper reports of activities in these segments coming to a standstill due to the demonetisation were abounded before the PMI’s arrival.

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The PMI surveys also sheds light on what participants believe about short and long run effects of demonetisation on growth. These appear to conform to a ‘short-term pain, long-term gain’ thinking; that is, the majority does not expect the negative impact of currency shortage to endure beyond the short-term. Surveyed manufacturers, for example, think that November data understates near-term disruption and expect a further drop in December. Importantly, they anticipate demonetisation “...to ignite growth in the long-run, as unregulated companies leave the market." Services firms seem to hold a similar belief. The future activity index is seen rising to 60.5 from 57.2, which is an indication that the sharp fall in the near-term is not expected to persist for long.

The real question therefore is what impact demonetisation could have on long-term growth. Will this be positive? Will growth in gross domestic product (GDP) accelerate, as is commonly regarded at this point? Or will it surprise on the downside?

Read more on demonetisation

Apart from the short-term pain, but long-term gain belief that prevails at this juncture, there isn’t any other guidance at this point. But one can look for answers to some of the questions. Consider for example, India’s current GDP growth profile. This is heavily dependent on consumption—private consumer spending to be precise. Private investment and exports are either absent or too weak to propel the GDP, while government spending is constrained by limits to resources and competing claims.

Will consumer spending rebound to previous levels a matter of two quarters? That is critical if current growth has to recover or reach higher levels. The answer to this is not straightforward because a measure that removes 86% of the monetary base in one stroke with intent to clamp down upon black money cannot but leave its mark upon spending pattern and behaviour, especially on consumption and its discretionary component. The direction and magnitudes of behavioural changes are unpredictable, as is their endurance; these are unlikely to be linear. Long run growth benefits cannot be taken for granted when behavioural, non-linear effects are considered.

Renu Kohli is a New Delhi based economist.

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