India’s GDP roller coaster:Following demonetization,board with care

We have divided growth after demonetization into the “quarters in pain” and the “quartersthat gain”. Starting with the former, growth is likely to be higher in the October 2016to March 2017 period than we had anticipated earlier (6.3% y-o-y versus 5.5%). Themain reason is that the contraction in currency was not too severe because cancellednotes were (selectively) in use even after November 8. In fact, activity indicatorsshow that sectors where old notes were permitted (agriculture, trade and utilities) aregrowing more quickly than others.

    With April, the new fiscal year FY18 will begin. The CSO has estimated that the“counterfactual GDP”, if demonetization had not happened, is around 7.1% in FY17.

    Consensus and RBI expect growth to rebound to 7.4% in FY18. They seem tobelieve that demonetization will add to growth. Is that feasible? We think not.

    We run a thought experiment to quantify the benefits of formalization and digitizationthat demonetization may have triggered. We estimate that the “black and casheconomy” of India stands at about 2% of GDP. If part of this is deposited into banksand can be loaned out, the ‘credit multiplier’ will get activated. Also, when in the bankingsystem, these funds become open to possible taxation, and the ‘fiscal multiplier’ willget activated. We estimate that the two multipliers can add ~80bp to GDP growth.

    On the other hand, to the extent that demonetization has stoked policy and economicuncertainty, it is likely to have pushed investment recovery out further into the future.

    Under plausible assumptions, we find that lower investment could subtract ~80bp fromgrowth, nullifying the positive impact of demonetization. In short we do not see thebasis for a v-shaped recovery; rather we expect it to be more u-shaped (see chart 3).

    Finally, we touch upon some oddities in the “new GDP data” which can bias numbers.

    First, the higher than previously anticipated growth over the short term (2HFY17) couldbe exaggerated further because the CSO has no way to collect informal sector datawhich is likely to have been hurt most by demonetization. Second, subdued growthover the medium term (FY18) could get dragged even lower by the auto-correction inGDP prints. Recall that India uses single deflation as opposed to double deflation,which has exaggerated growth prints in the past, but is now autocorrecting, as oil pricesrise. It would be wise to interpret the upcoming GDP releases on February 28 andthereafter, with care.