Three Charts That Tell Us How Demonetisation May Hit GDP Growth

As the dust begins to settle on demonetisation, brokerages and analysts are trying to predict the economic impact of the move which has resulted in a severe cash crunch across the country. While the government’s decision to withdraw old Rs 500 and Rs 1,000 notes, which account for 86 percent of the total currency by value, may help curb the black economy, it will also dent the broader economy.

On November 18, brokerage house Ambit Capital cut its GDP growth forecast for financial year 2017 by 330 basis points to 3.5 percent. Others, like HSBC, see a smaller hit of 0.7-1 percent to GDP growth over a year.

In a November 21 report, brokerage house Motilal Oswal said that the impact of GDP growth will depend on the proportion of cash that does not return to the banking sector. The demonetisation decision scrapped over Rs 14 lakh crore in currency. In the first eight days since the announcement, November 10-18, banks have accumulated Rs 5.44 lakh crore in old currency.

According to the Motilal Oswal report, the currency that does not come back will lead to a reduction in broad money supply as measured by M3. M3 is the broadest measure of money in the economy which includes currency in circulation, demand deposits and repurchase agreements that do not mature in the very near term.

Since demonetisation is likely to reduce the flow of cash in the economy in the short term, any increase in bank deposits will reduce money supply.

While no one has a fix on how much currency will not return to the system, broad assumptions are being made based on the size of India’s black economy. In 2013, McKinsey & Co. estimated that the shadow economy is about 26 percent of GDP. Assuming that figure is accurate, if roughly 25 percent of currency was to not return to the banking sector, money supply growth would reduce by 4 percent, said the report.

This, the brokerage said, is going to affect nominal GDP growth, going by Milton Friedman’s quantity theory of money. This theory, in its simplest form, says that supply of money multiplied by velocity of money is equal to price levels multiplied by real GDP growth (nominal GDP growth).

As a result, if M3 remains at Rs 125.22 lakh crore at the end of March 2017, the nominal GDP growth is likely to reduce to 8.2 percent in FY17 as against the pre-demonetisation forecast of 11.5 percent. This assumes that the velocity of money remains the same in the economy.

The Motilal Oswal report said that it is difficult to project the actual velocity of money because of two contrary forces at work. First, the high number of transactions as citizens attempt to get rid of their old currency notes of Rs 500 and Rs 1,000, will likely increase velocity. The second and opposing force, fewer transactions in the aftermath of demonetisation as discretionary spending reduces.

However, if the reality indeed proves closer to the assumptions in this model, real GDP growth could fall to just four percent – down from the pre-demonetisation expectation of 7.7 percent, the brokerage said.

An estimated real GDP growth of 7.4 percent year on year in the first half of FY17 implies a GDP growth of less than 2 percent in the second half of FY17, the brokerage house said, while adding that short-term pain, in terms of GDP growth is “almost inevitable”.