As the economy is cash-dependent, it will have a material impact on growth, inflation, fiscal and rates/liquidity, though the scale depends on the transition period. Demand for consumer durables and discretionary spending will be hurt for two quarters. Rural demand, especially unbanked sections, too will moderate.
This raises downside risks to the tune of 40-80 bps to growth. The longer-run boost to growth will accrue from a smaller shadow economy and bigger proportion of cashless transactions, assuming that the other pro-growth reforms stay on track.
In addition, the short-term monetary shock will depress demand and consumption. When combined with tame food prices due to a normal southwest monsoon, FY16/17 inflation might average 20 bps below our 4.8 per cent annual CPI estimate. This, to some extent, offsets the boost from higher public sector wages, leaving the door open for a 25 bps cut in 1Q17. The scope of a rate cut in December, however, is low after the pre-emptive rate cut in October and rupee weakness due to external uncertainty.
On the fiscal end, windfall tax gains are likely if unaccountable money is unearthed. It will increase the proportion of direct tax revenues over indirect collections. This assumption carries two risks.
First, estimates of the extent of black money in the economy vary widely. This risks overestimating the potential fiscal boost. Two, if this initiative hurts growth sharply, the net boost to tax revenues will be diluted by a drop in overall collections. Moreover, this is affecting the passage of other reforms in the ongoing Parliament session.