Moody’s Warns India: Demonetization to Upset Economy

India’s decision to scrap some high-value notes will significantly disrupt economic activity, result in weaker consumption and economic growth in the immediate term but is expected to boost tax revenues and trigger faster fiscal consolidation in the long run, global ratings agency Moody’s said on Thursday.

“Corporates will see economic activity decline, with lower sales volumes and cash flows. Those directly exposed to retail sales will be most affected,” Laura Acres, a managing director in Moody’s Corporate Finance Group said in a new report on demonetization, news outlets reported.

In a separate analysis, the Center for Monitoring Indian Economy estimated the transaction cost of demonetization at Rs 1.28 lakh crore ($186.9 billion).

“All estimates are limited to the 50-day window. However, the impact of low liquidity, broken supply chains and loss of confidence in consumers is likely to impact the economy over a longer period. Therefore, the transaction cost of this exercise is more than the Rs 1.28 lakh crore estimated here, which is limited to the 50-day window till December 30,” Mahesh Vyas, managing director of CMIE, said in a report.

Moody’s said households and businesses will experience liquidity shortages as cash is taken out of the system, with a daily limit on the amount in old notes that can be exchanged into new notes. (The government stopped the exchange from Friday).

In addition, there will be a loss of wealth for individuals and corporates with unreported income, as some will choose not to deposit funds back into the formal financial system to avoid disclosing sources of these funds, the agency said.

  Economic Disruption

The agency said the move would improve the overall operating environment for doing business in India—by improving the ease and speed at which payments reach manufacturers and reducing corruption—but would prolong the economic disruption. “However, greater formalization of economic and financial activity would ultimately help broaden the tax base and expand usage of the financial system, which would be credit positive,” Moody’s said.

In the nearer term, however, Moody’s expects asset quality to deteriorate for banks and non-bank finance companies, as the economic disruption will significantly impact ability of borrowers to repay loans, mainly in case of loans against property, commercial vehicle and micro finance sectors.

“A prolonged disruption could also have a more significant impact on asset quality, as both corporate and small- and medium-sized enterprise customer have a limited ability to withstand a sustained period of economic weakness,” Moody’s said.

  Macro-Economic Effects

Fitch Rating agency said on Friday that a delay in consumption and investment, disruptions to supply chains and farmers being unable to buy inputs could be some macro-economic effects of the demonetization.

Director of the agency’s Asia-Pacific Sovereigns Group Thomas Rookmaaker said the discontinuation of the high-value notes was a one-off event which would not generate a significant structural shift in economic activity from the informal to the formal sector.

“There are many elements to the demonetization, which makes it difficult to quantify the impact on real gross domestic product growth and explains the wide range of forecasts by different analysts,” Rookmaker said. There will be a likely decline in GDP growth for this quarter, but the impact for the financial year as a whole may still be moderate, he said.

  Monumental Mismanagement

Former Indian prime minister Manmohan Singh has rubbished the government’s move to ban two major currency notes, calling it “monumental mismanagement”.

Singh, the architect of economic reforms in the 1990s, said GDP would fall “by about 2%” because of the move.

Earlier this month Prime Minister Narendra Modi announced that 500 and 1,000 rupee notes had become illegal as part of a crackdown on corruption. But scarcity of new notes has brought the economy to a virtual standstill.

Singh, who is credited with opening up India’s economy when he was finance minister in 1992, told MPs the move “can weaken and erode our people’s confidence in the currency system and in the banking system”. He said it amounted to “legalized plunder”.