In the short-term, demonetisation may lower growth, and consumption may weaken until cash normalcy is restored. While rural demand is likely to be pressured because of its higher reliance on cash transactions, urban demand too would suffer, especially consumer durables.
This would add to the downside risks to the already sluggish industrial production and investment trends. Hence, it is possible that FY17 growth will dip below 7 per cent. That said, easing growth will intensify downside pressure on inflation, opening the room for further interest rate cuts and providing a floor to growth.
This is a step in the right direction and should bolster India’s pro-reform image, provided the government effectively addresses the numerous logistical issues that have mushroomed over the past couple of weeks, inconveniencing citizens. The jury is out on whether the execution could have been better.
To the extent that the success of the policy depended on its secrecy, some disorder is, perhaps, inevitable. Nonetheless, the key challenge for the government now is to restore normalcy. If not, the simmering social unrest, especially in rural India, could degenerate into a civil backlash – with the subsequent economic and social losses making this the biggest failed economic experiment globally.
Demonetisation may not eliminate India’s parallel economy. But its size is likely to shrink, bringing more people within the tax net. Currently, India has one of the lowest tax bases in Asia.
An increase in the tax-to-GDP ratio may help India raise spending, while still adhering to its fiscal consolidation roadmap. Managed properly, demonetisation can improve the investment climate by reducing corruption concerns, but also pave the way for more fiscal support to growth and infrastructure spending.