Impact of India’s Demonetization Worse Than Expected


After last month’s demonetization of the largest rupee notes, it appears that the full impact has yet to be felt. Policymakers may have underestimated the potential negative fallout from the move, both economically and politically.


The decision to remove all 500 and 1000 (the largest denominations) rupee notes from circulation on November 8 was surprising, to say the least.  The move was ostensibly made to root out counterfeit notes as well as so-called black money. Estimates suggest that 86% of all currency was taken out of circulation. Holders of these bills need to deposit them into bank accounts by December 30, but the end result has been a serious cash crunch.

State elections in Uttar Pradesh will be held early next year. The state of Punjab will hold elections later. If the situation worsens, Modi’s BJP could end up paying the price. RBI Governor Patel was recently heckled at a public appearance. Clearly, the populace is still upset with the government’s handling of the demonetization.

National elections won’t be held until mid-2019. Despite ill will stemming from the demonetization, support for Modi is likely to remain strong enough to give the BJP a second five-year term. The opposition has been leading popular and parliamentary protest, but it remains to be seen whether they can truly capitalize on the current fallout.


The economy is being impacted negatively by the demonetization scheme. Anecdotal evidence suggests some sectors of the economy are barely functioning as a result of the cash crunch. The Reserve Bank of India just cut its growth forecast for FY2016/17 from 7.6% to 7.1%, but maintained its 7.6% forecast for FY2017/18. We see downside risks to these forecasts.

Minutes from the last meeting show the central bank viewed the impact of the cash ban as “transitory” but worth monitoring. GDP rose 7.3% y/y in Q3, but Q4 is expected to slow to 6.6% y/y due to the demonetization. This slowdown is likely to carry over into 2017 if the cash crunch is not alleviated soon.

Price pressures are easing, with CPI decelerating to 3.63% y/y in November. This is the lowest rate since November 2014. The RBI targets 4% inflation within a 2-6% range. WPI inflation has also eased to 3.15% y/y. While this should be supportive of further easing, the central bank recently warned of upside risks to inflation from higher commodity prices and the weak rupee.

Indeed, the Reserve Bank of India surprised the markets by keeping rates steady at its November meeting (25 bp cut expected). This came after it surprised markets with a 25 bp cut to 6.25% back in October (when steady rates were expected). The next RBI policy meeting is February 8, and much will depend on external conditions. Higher commodity prices and/or a weaker rupee could keep the RBI on hold again. Ongoing uncertainty related to the cash crunch could also lead to steady rates.

Fiscal policy is likely to be negatively impacted by the demonetization. The Goods and Services Tax (GST) bill is making its way through parliament. Passage had been expected next year, but this has likely been delayed by disruptions from the demonetization. Indeed, some analysts see 2018 as more likely now in terms of GST implementation. The slowdown in the economy from the demonetization will hurt revenues and put upward pressure on the budget gap as we move into 2017.


The rupee has generally outperformed in EM. In 2015, INR lost -5% vs. USD. This was behind only the best performers TWD (-4%) and CNY (-4.5%). So far this year, INR is -3% YTD and is around the middle of the EM pack. The best performers YTD are RUB (+21%), BRL (+20%), and ZAR (+10%), while the worst are ARS (-18%), MXN (-17%), and TRY (-17%). Our EM FX model shows the rupee to have NEUTRAL fundamentals, so this year’s “so so” performance is to be expected.

USD/INR has not yet retraced half of the November-December drop. A break above 68.10 (50%) and then 68.28 (62%) is needed to set up a test of the all-time high near 68.86 from November.

Indian equities have underperformed this year after a solid 2015. Last year, MSCI India was -3% while MSCI EM was -17%. So far in 2016, MSCI India is -3% YTD, and compares to +5% YTD for MSCI EM. This underperformance should ebb a bit, as our EM Equity model has India at a NEUTRAL position.

Indian bonds have outperformed this year. The yield on 10-year local currency government bonds is about -123 bp YTD. This is behind only Brazil (-484 bp) and Colombia (-154 bp). With inflation likely to reverse and move higher and the central bank’s easing cycle on hold indefinitely, we think Indian bonds will start underperforming.

Our own sovereign ratings model shows India to have an implied rating of BBB/Baa2/BBB. This is a notch above actual ratings of BBB-/Baa3/BBB- and so we see some upgrade potential.