Banknote blip

Shaving 100 bps off our fiscal 2017 GDP call

December 1, 2016

Any disruption in the flow of money, verily the economys lifeblood, impacts business cycles quickly. And more
so if it is of an order of magnitude.
The 8/8 move or the announcement made by Prime Minister Narendra Modi ~8 pm on November 8 to
demonetise Rs 500 and Rs 1,000 bank notes turned 86% of the currency in circulation by value into absolute
trash with near-immediate effect. Problem is, the infusion of replacement notes has been very sluggish and
the ensuing cash choke has pulled back the business cycle, which was beginning to accelerate on the back of a
good monsoon, the Seventh Pay Commission pay hike, and the One Rank One Pension scheme for veterans.
Today, there is uncertainty on how much time it will take for a return to BAU, or business as usual. By that, we
dont mean all the ~Rs 14 trillion of Rs 500 and Rs 1000 bank notes getting replaced. Thats unlikely in any
case, given that demonetisation has spawned the largest and fastest shift to a less-cash economy as
hundreds of thousands of people are trying out digital payments for the first time. So a replacement
reasonably lower than Rs 14 trillion can be a return to BAU. Yet, the overall uncertainty, together with a fall in
consumption demand and inventory build-up, will push back recovery in private corporate investments.
The channels through which demonetisation will work on GDP are broadly understood, but the extent of impact
will depend on the time taken to get the cash plumbing working as before. The problem gets compounded
because of a preponderance of cash transactions in the humongous informal sector, which cannot be
accurately measured or monitored. We believe the cash crunch will impact private consumption demand (55%
of GDP) directly, and cull GDP growth in the third and fourth quarters of the current fiscal.
Assuming that it will take at least a couple of months for the situation to normalise, we have sliced 100 basis
points off this fiscals GDP growth to 6.9% from 7.9% estimated earlier. That translates into a GDP growth of
6.6% for the second half, compared with 7.2% in the first half. The jolt to demand will also pull inflation down.
We now expect the Consumer Price Index (CPI)-based inflation to print lower at 4.7% compared with our earlier
forecast of 5%.
So while the pain of demonetisation will be frontloaded, the benefits will be felt over a period of time. We
expect GDP growth to rebound next fiscal -- over the weak base of fiscal 2017 -- and assuming a normal
monsoon. In the medium run, it will strengthen the governments fiscal position as tax compliance improves.
That will provide an opportunity to cut the tax rates.
We will monitor the evolving macroeconomic scenario and make adjustments to our outlook as needed.
CRISIL outlook for fiscal 2017
Fiscal 2015

Fiscal 2016

Fiscal 2017 F

Total GDP (y-o-y,%)

7.3

7.6

6.9

Agriculture

-0.2

1.1

4.0

Industry

5.9

7.4

6.1

Services

10.3

8.9

8.0

CPI inflation (%, average)

6.0

4.9

4.7

Fiscal deficit (% of GDP)

4.1

3.9

3.5

10 year G-sec yield (%, March-end)

7.7

7.5

6.5

Current account deficit (% of GDP)

1.3

1.1

0.9

Rs per $ (March-end)

62.6

66.3

67

Source: CSO, CRISIL Research; Downward bias

GDP growth in the first half of fiscal 2017 was 7.2% compared with 7.5% in the same period of fiscal 2016.
After demonetisation, we expect it to be reasonably lower in the second half.

The primary and immediate channel for deceleration would be the slowdown in consumption demand.
India is largely a cash-based economy. According to a 2013 report 1, the value of cash transactions in India
as a percentage of total consumer payments was approximately 86% in 2012. This number might have
come down in last few years led by some pick-up in electronic transactions, but would still be significantly
high.

Private consumption, at around 55%, is the biggest contributor to Indias GDP. While it is difficult to
quantify the exact impact of demonetisation, directionally it would be negative in the short run and if BAU
doesnt return soon, the slowdown may spill over into the next fiscal because of a delay in private
investments.

While ongoing investments might not slow down, fresh investment plans may be put on ice if private
consumption doesnt pick up and uncertainty continues, which, in turn, would further delay the muchneeded recovery in Indias private investment cycle.

While it is certain that the sudden removal of the 86% of the currency in circulation is bound to hit
consumption-led growth in the economy, the magnitude of impact on various sectors would depend on the
relative size of their cash component. Roughly, these sectors could be bucketed into low, medium and high
categories based on their cash component.

Relative size of cash component in various sectors

High

Medium

Low

Consumer staples retail

Real Estate

Automobile retail

Consumer durables retail

Furniture retail

Auto Components (OEM & aftermarket)

Gems & Jewellery

Chemicals

Textiles trading & retail

Cement

Long steel products

Textiles spinning

Building products
(excluding cement)

Finished leather & leather products

Paper and printing
Rubber products and processors

Source: CRISIL Research estimates

N Joseph, R Korenke, B D Mazzotta and B Chakravorti, Cash Outlook: India, IBGC Working Paper 13-01, The Institute For Business in the
Global Context, The Fletcher School, Tufts University

As far as the supply side is concerned, while the current sowing season seems to be progressing well (see
table below), the agriculture sector would still bear the brunt of demonetisation in the third quarter (where
earlier a large pick-up in agricultural GDP growth was envisaged). Thats because farmers are finding it
tough to sell their produce in the APMC markets. Therefore, despite a good harvest, there is unlikely to be a
commensurate improvement in rural demand.

Area sown under Rabi crop as on November 25, 2016

Crop

Area sown, fiscal 2017

Area sown, fiscal 2016

127.15

117.32

Wheat
Rice

6.82

9.10

Pulses

95.09

88.12

Coarse Cereals

34.35

42.37

Oilseeds

64.21

56.26

Total

327.62

313.17

Source: Ministry of Agriculture

Non-agricultural GDP, too - both industries (slower manufacturing and construction) and the services
sector (real estate, transportation etc) would be negatively impacted.

On the whole, GDP growth in the second half would be lower than in the first, and we scale down our real GDP
growth projection for the current fiscal to 6.9% from 7.9% earlier.

GDP growth to be lower in the second half

Real GDP Growth (%, y-o-y)
7.2
6.6

H1 FY17

Source: CSO, CRISIL Research

H2 FY17 f

f = Forecast

Second-quarter growth brought some cheer, though

Indias GDP registered some pick up in the second quarter of the current fiscal. According to latest data, real
GDP growth in the second quarter, or July-September, was 7.3%, up from 7.1% in the first quarter, or AprilJune. As anticipated, this years normal and well-distributed monsoon gave a fillip to the agricultural sector,
where growth shot up to 3.3% in the second quarter, compared with 2% in the same period of fiscal 2016. In
the second half, we expect agricultural GDP growth to lift to 5.4%.

Growth mildly up in the second quarter

7.9
7.6
7.3

7.2
7.1

Q2

Q3

Q4

Q1

FY16

Q2
FY17

Source: CSO

Nuances of GDP growth (%, Y-o-Y)

At basic prices

Q2

Q1

Q2

H1

H1

FY16

FY17

FY17

FY16

FY17

At market prices

Q2

Q1

Q2

H1

H1

FY16

FY17

FY17

FY16

FY17

Agriculture & allied

2.0

1.8

3.3

2.3

2.59

Pvt. Consumption

6.3

6.7

7.6

6.6

7.14

Industry

6.3

6.0

5.2

6.5

5.59

Govt. Consumption

3.3

18.8

15.2

1.5

17

o/w Manufacturing

9.2

9.1

7.1

8.2

8.1

Fixed Investment

9.7

-3.1

-5.6

8.4

-4.3

Mining

5.0

-0.4

-1.5

6.7

-0.9

Exports

-4.3

3.2

0.3

-5.0

1.76

Services

9.0

9.6

8.9

8.9

9.22

Imports

-0.6

-5.8

-9.0

-1.5

-7.4

Source: CSO, CRISIL Research

Inflation to dip, December rate cut on the table

CPI inflation is expected to print at 4.7% for fiscal 2017, or 20 bps lower on-year and 30 bps lower than our
previous estimate, which creates ground for a 25 bps repo rate cut by the Reserve Bank of India (RBI) during its
monetary policy review on December 7. However, the RBIs move to impound excess liquidity by mandating
100% cash reserve ratio on incremental deposits raised during September 16 and November 11, could slow
interest rate transmission a bit, and cause a blip in bond yields. Also, it is expected to continue siphoning out
excess liquidity from the banking system which will put upward pressure on yields. We therefore expect the
10-year benchmark yield to settle around 6.5% by the end of the current fiscal -- with a downward bias.

Food inflation is expected to continue to decline for a few months more because of a bumper crop. The fall
in the prices of perishables will also bring inflation down temporarily. Additionally, government measures2
to ease the cash crunch for farmers and mandi traders may ensure that food supply is less adversely
impacted. India spends nearly 50% of its wallet share on food, where the end-consumer mostly transacts
in cash. The pain, therefore, would be from tardy infusion of new banknotes, which will artificially curtail

As follow-up measures to the demonetisation drive, the government has allowed rabi crop growers to purchase seeds using old
denomination bank notes from designated outlets in addition to withdrawal Rs 25,000 per week against sanctioned crop loans or kisan
credit cards. Also, registered traders operating in APMC governed mandis are now permitted to withdraw Rs 50,000 per week from their
bank accounts.

demand. But its dampening impact on food inflation could be offset by supply disruptions caused by the
inability of farmers/traders/transporters to use cash.

Core inflation (52% of CPI and sticky) is expected to slow and remain subdued as demand dips. Also, the
rural areas, which have a higher share of cash transactions, could see a sharper fall in inflation compared
with urban. Categories such as housing, transport, trade in household goods, consumer services including
eating out that tend to have a higher cash component in transactions could see downward price pressure
in the coming months. The rising risks to growth and reducing upside to inflation is likely to be a key
trigger for a repo rate cut on December 7.

Some upside from a bump up in imported inflation -- as the rupee weakens and oil prices strengthen -could limit the slide in inflation in the short term.

Meanwhile, the narrowing differential between the 10-year yields in India and the US is causing an
outflow of foreign institutional investor (FII) funds. Between November 8 and 30, net FII outflows from the
Indian debt market was $3.1 billion. During this period, the 10-year G-sec yield fell nearly 60 bps, while
that on equivalent US treasury rose over 40 bps, spurring FII outflows. This contributed to the sharp
depreciation in the rupee, which was already feeling the impact of redemption of foreign currency nonresident bonds and strengthening dollar. Once the dust settles on demonetisation, we expect Indian
macros low inflation and CAD, and better growth prospects - to reassert themselves, and the rupee to
settle ~67 per dollar by the current fiscal end.

Fiscal implications: Neutral in the short run, positive over medium run
We expect the government to meet its fiscal deficit target of 3.5% of GDP for this year. There would be some
gain in direct tax collections as more people deposit undeclared cash. The flipside, however, is that the last
two quarters of this fiscal will also see a fall in demand, which could have a bearing on indirect tax collections.
So, on a net basis, the governments tax revenues are unlikely to see any significant gain in the current fiscal.
Over the medium term, however, there would be a positive impact on tax collections, and the governments
ability to spend on infrastructure would improve, leading to faster growth. Higher income tax collections
arising from better compliance would also offer scope to reduce income tax rates over the long term, which
would increase disposable incomes. The virtuous cycle set off would improve long-term consumption demand.

World economy offers no help

Recent political developments such as Brexit and the election of Donald Trump reflect growing sentiment
in many advanced economies against openness in global trade

Such protectionist stance in the backdrop of tepid external demand will reduce external stimulus to
growth for developing countries, including India

Advanced economies are recovering slowly and steadily on the back of monetary (and in some cases, fiscal)
stimuli. The International Monetary Fund has projected that global growth would slow 10 basis points (bps)
from 2015 (calendar year) to 3.1% in 2016, before clawing up to 3.4% in 2017. However, geopolitical
developments such as Brexit are casting a long shadow on global growth. The idea of the European Union (EU)
is based on free movement of goods and labour, which Britons felt was hurting their national interest.

On the other side, the largest economy in the world the Unites States has elected Donald Trump as its
president. Trump had campaigned extensively against the Trans-Pacific Partnership (TPP) the mega free
trade agreement involving 12 countries in the Asia Pacific as also against the North American Free Trade
Agreement (NAFTA) and immigration. His victory shows many Americans share the sentiments of the British on
international trade integration.
According to S&P Global3, sluggish economic recovery, which has only recently brought about stronger job
gains and a pickup in wages, may help explain the virulent response to free-trade proposals -- the fear being
that Americans would lose more jobs overseas.
On the whole, nationalism seems to be on a rise at the cost of international trade. This us-versus-the-world
refrain is detrimental to developing economies, including India. China and other east Asian countries were able
to achieve high growth primarily due to booming exports, which were supported by a benign global
environment, and broad support for international trade integration. Now, not only is global trade slowing due
to sluggish macroeconomies, but is also flanked by the risk of advanced economies turning protectionist. This
poses a major threat at a time when the Modi government is pushing for growth through its Make in India
program.
However, whether the advanced economies actually become protectionist remains a trillion-dollar question.
For the United Kingdom to commence the process of exiting the EU, it needs to trigger Article 50 of the Treaty
of Lisbon, which the UKs Prime Minister Theresa May has indicated will not happen before March 2017.
Hence, the nature of trade agreements that Britain will form with individual countries will remain uncertain for
some time. There is also a high degree of uncertainty regarding the policies Trump will choose to pursue (and
how successful he will be in implementing them) 4.

Analytical Contacts:
Dharmakirti Joshi

Dipti Deshpande

Adhish Verma

Chief Economist, CRISIL Ltd.

dharmakirti.joshi@crisil.com

Senior Economist, CRISIL Ltd.

dipti.deshpande@crisil.com

Economist, CRISIL Ltd.

adhish.verma@crisil.com

Pankhuri Tandon

Hetal Gandhi

Economic Analyst, CRISIL Ltd.

Associate Director, CRISIL Ltd

pankhuri.tandon@crisil.com

hetal.gandhi@crisil.com

Media Contacts:
Shamik Paul
Media Relations
CRISIL Limited
D: +91 22 3342 1942
M: +91 99208 93887
B: +91 22 3342 3000
shamik.paul@crisil.com
3
4

Khushboo Bhadani
Media Relations
CRISIL Limited
D: +91 22 3342 1812
M: +91 72 081 85374
B: +91 22 3342 3000
khushboo.bhadani@crisil.com

S&P Global (10 November 2016). Can President Trump reshape the US economy? S&P Global Economic Research.
S&P Global (11 November 2016). U.S. Weekly Economic Roundup: The Times They Are A-Changin'. S&P Global Economic Research

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