India: where is the negative impact of demonetization?

13 March 2017 13:02 RaboResearch

The Indian economy grew by 7% in Q4 of 2016, which is surprising given that India was struck by an unexpected demonetization operation. The explanation can be found in underrepresentation of the informal economy in statistics and overestimation of the role of the private corporate sector.

The demonetization puzzle

GDP data released by the Central Statistical Office (CSO) on 28 February showed that the Indian economy grew by 7% in the fourth quarter of last year, which is the third quarter of the fiscal year. This figure is surprisingly high, given that India was struck by a surprise demonetization operation in November 2016, replacing 86% of all currency in circulation. Many analysts expected large negative effects on private consumption and investment, but so far the economy seems to hold up remarkably well. Prime Minister Modi has used these newly-published data to his advantage, by emphasizing that opponents of his demonetization scheme were wrong in their assessment of the negative effects. This is especially convenient as the largest state Uttar Pradesh (UP) is currently electing its new assembly in different stages, which will reach its phase of completion on 15 March. Still, the question remains: is the Indian economy the best practice of resilience, as it seems to weather even the most surprising heavy economic shocks? Or do the data not tell the whole story?

What was demonetization again?

Just to refresh your memory, on 9 November 2016, Prime Minister Modi announced that the INR 500 and INR 1,000 currency notes were no longer legitimate means of payment, and that people were given the opportunity to exchange these old notes for newly-developed INR 500 and INR 2,000 INR notes until the end of the year. All incidences of extraordinary deposit growth were to be subject to a tax investigation by the authorities. With this so-called demonetization plan, 86% of the currency in circulation was replaced and this resulted in a huge monetary squeeze (Figure 1). The plan was an attempt by the government to wash the stock of counterfeit money out of the economy, which has allegedly been used to fund criminal activities, such as terrorism and drug trafficking. In addition, the scheme aimed to draw a large part of the black economy into the banked and taxable part of the economy (overall tax revenue to GDP is a meagre 11%). The demonetization plan could be beneficial for India in the longer run, as it will lift government revenues due to a broader tax base and less tax evasion. In addition, the operation will foster the use of bank accounts and digital payments, making the Indian economy less cash-dependent and improve efficiency and productivity.

Figure 1: The big squeeze: monetary base declined from INR 22.5trn to 13.7trn

Source: Macrobond, Rabobank

Is the worst already over?

In the short run, however, the cash crunch should have sizeable negative effects. First of all, India has a substantial informal economy, contributing 46% to non-agricultural Indian GDP and encompassing 84% of the non-agriculture jobs (see ILO, 2013). The informal sector is very cash-dependent and the liquidity squeeze should have put a brake on transactions, especially in sectors such as retail, agricultural and commodities. Many entrepreneurs in the agricultural and retail sector do not have bank accounts, do not pay taxes and run their daily business solely based on cash transactions. During the note ban, these parties were not able to pay their workers in cash, buy intermediate goods in cash and sell their products and services for cash. Second, the crackdown on black money, which has been hoarded in the real estate sector, will most likely result in lower house prices and, hence, negative wealth effects[1]. This is also detrimental for private consumption and housing investment. In response to the demonetization operation, many analysts have revised their growth expectations for the fiscal 2016/2017 (April 2016-March 2017) downwards (Table 1).

[1] Prime Minister Modi has also signaled that the demonetization was a first step against corruption and tax evasion, and property records will be digitalized as well. These digital records are used to identify individuals who have been registering assets under other peoples’ names in order to avoid taxes. The property digitalization operation will put additional stress on the real estate sector.

Table 1: Many institutes revised FY2016/2017

Source: IMF, World Bank, RBI, Rabobank

Latest readings are (too) positive

The latest data release, however, shows that the Indian economy grew by 7% (year-on-year) in the fourth quarter of 2017, which is at odds with expectations. Private consumption contributed strongly to growth by 5.7 percentage points (Figure 2). Moreover, other drivers were government investment and consumption, contributing an addition 3 percentage points to the headline figure.

If we look at the sector contribution to the macro growth figure, the real estate sector seems to have taken a hit in the fourth quarter, but this was largely counterbalanced by a strong contribution of the agricultural sector and manufacturing, two sector which were also expected to be damaged by demonetization due to heavy cash-dependency and shrinking investment, respectively (Figure 3).

Figure 2: Indian economy didn’t budge in Q4

Source: Macrobond, Rabobank

Figure 3: Lower real estate activity has been counterbalanced by higher manufacturing and agricultural activity

Source: Macrobond, Rabobank

Going forward, the purchasing managers’ index (PMI) shows a large rebound, indicating the worst of the demonetization may already lie behind us (Figure 4). The same sharp rebound is also visible in vehicle sales. The sales of especially two wheelers, the largest component within total sales, contracted by 12% (% mutation month-on-month) in November and 20% in December, but also shows a rebound in January (+23%). Admittedly, the amount of sales is still far below peak sales in August and September 2016, but the recovery definitely suggests that sales have been delayed rather than cancelled.

Figure 4: PMI points to a rebound

Source: Macrobond, Rabobank

Figure 5: Vehicle sales shows a sharp V-shape rebound

Source: Macrobond, Rabobank

Measurement issues

The most important explanation why the cash crunch did not produce a big dip in the Q4 GDP figures might be found in the quality of Indian statistics. Two major issues are at play here (see Nagaraj and Srinivasan, 2016). First, the CSO is overstating the contribution of the private sector. In 2015, the CSO changed its methodology to measure GDP. Before this revision, only a small number of companies actually filed their balance sheets to the firm administrator, due to poor law enforcement. The firms that did register their financial metrics were used as a sample and the data was scaled up. However, this method became unreliable, as the number of registrations increased substantially, but filings of balance sheets data remained low. Many of these new registrations were so-called shell companies, which were used to run black money through the economy (see The truth behind India’s new GDP number). Since 2006, the Ministry of Corporate Affairs (MCA) has increased its effort to persuade companies to file their returns, for instance by threats of de-registration.

In the 2015 revision, the improved database of the MCA has been by the CSO to produce more reliable national accounts data for the private corporate sector. However, the CSO is still using a scale factor to blow up the sample of companies in the database, whereas many question if the number of companies in the database is not the actual number of active companies. By using a scale factor, the CSO would be overstating the size of the private corporate sector. Overstating the private sector might be the main cause for the high manufacturing contribution to GDP growth. Indications of industrial production (IIP: Industrial Production Index) for manufacturing shows subdued growth or even contraction. And even if we consider the IIP for eight key sectors of the Indian economy, we don’t arrive at the high growth of manufacturing value added reported by the CSO (Figure 6).

The second data issue is related to measurement of the informal economy, which is, as stressed, very substantial in India. Although the CSO has revised its proxy of informal sector activity[2], there are still concerns that the national accounts statistics is biased towards the registered and taxable part of the economy. Nagaraj and Srinivasan (2016) state: “We have reasons to suspect that the new methodology for estimating labour input has underestimated the contribution of the unorganized sector to domestic output.” This possible underrepresentation is worrying, as the unorganized part of the economy especially has borne the brunt of the demonetization operation.

[2] Before the revision, the magnitude of informal sector output was proxied by combining information on value added per worker from national surveys with employment data per industry.

Figure 6: Don’t see the correlation? …We don’t either

Source: Macrobond, Rabobank

Calm before the storm?

Although the effect of demonetization perhaps did not cause the economic hurricane that some analysts expected, we believe the slight puff of headwind that the economy has faced up till now won’t be all of it. Ultimately, the negative effects are dependent on the period of time before liquidity in the economy has returned to pre-demonetization levels (Figure 1). The gap between former and current levels is still substantial and we believe the negative effects on the Indian economy might reveal themselves in upcoming revisions of GDP or when more reliable informal sector data is released next year. As for now, we will stick to our forecast and expect the Indian economy to grow by 5.5% in FY2016/2017 and 8.2% in FY2017/2018. The pick-up in growth later this year is due to important reforms that Modi has been able to implement, such as the Goods and Service Tax (GST), which brings uniformity in India’s complicated and inefficient tax scheme and reduces the cascading effect in the old system. The implementation is most likely due in July 2017, and will result in lower prices of goods and services, as well higher investment and tax revenues.