The severity of the cash crunch, in conjunction with a slow pace of remonetization, led to a slowdown in economic activity in India

Regional Economic Outlook, Asia and Pacific-IMF

On November 8, 2016, the Government of India withdrew the legal tender status of all existing 500 and 1,000 rupee banknotes, effective the next day, in a bid to nullify black money hoarded in cash, address tax evasion, tackle counterfeiting, and curb financing of terrorism. The initiative affected notes with a total value of about 15 trillion rupees, which accounted for about 86 percent of all cash in circulation. At the time of the withdrawal, the introduction of a new series of 500 and 2,000 rupee banknotes was announced. However, the supply of new banknotes in the months following the initiative was insufficient, even as the authorities took multiple steps to ease the currency transition. While there was no limit on the amount of bank deposits for the phased-out bills, the scarcity of new banknotes prompted the government to suspend cash exchanges and impose tight caps on cash withdrawals by individuals as well as by corporations. As disruptions to payments arose, several temporary exemptions were granted to ease the cash crunch. These exemptions aimed at easing transactions in some public offices and for the farming sector, as well as making payments for public utility services and purchasing key primary products.

The key factor behind the short-term economic disruptions was the primarily cash-based nature of the Indian economy and its limited electronic payments infrastructure. At end-2015, currency in circulation in India stood at about 12 percent of GDP, one of the highest levels among countries covered by the Bank for International Settlements' Committee on Payments and Market Infrastructure. Cash accounted for about threequarters of the narrow money base, as a large number of households (particularly in rural areas of India) rely on cash for everyday transactions. Numbers of bank branches and ATMs per capita are relatively low in India; few payment cards with a cash function exist; and the average number of transactions per Indian made with payments instruments in 2015 totaled 11 transactions.

The severity of the cash crunch, in conjunction with a slow pace of remonetization, led to a slowdown in economic activity. India's Purchasing Manager's Index for services, which also covers retail and wholesale trade, collapsed from 55 in October 2016 to 43 in November, 2016. The growth of credit to the nonfood private sector decelerated from 9 percent at end-October 2016 to a 10-year low of just 4 percent by end-December, 2016. The consumer goods component of the index of industrial production declined by about 7 percent in December 2016, with production of consumer durables falling by 10 percent. Domestic sales of motor vehicles declined by 20 percent in December 2016 compared to December 2015, with the largest drop taking place in India's mass-consumer-oriented segment of three-wheel and two-wheel passenger vehicles. Although the slowdown in industrial activity has been relatively muted, with overall industrial production falling by less than of 1 percent from the previous year, investment activity appears to have been severely affected. As per the data compiled by the Centre for Monitoring of Indian Economy, the number of new investment projects announced during the October-December 2016 quarter was the lowest in over a decade, and their combined value was only about one-half of the average recorded during the previous two years. While the remonetization proceeded slowly over the first few months, about 75 percent of the pre-demonetization level of currency in circulation was restored by late March.

IMF staff analysis suggests that, compared to the October 2016 IMF World Economic Outlook forecasts, cash shortages are likely to slow FY2016/17 growth by about 4/5 of 1 percentage point and FY2017/18 growth by about of 1 percentage point. A decline in currency supply can be calibrated as a temporary tightening of monetary conditions, using previous money demand studies for India.1 The currency shortage associated with the currency exchange, assumed by the staff to gradually unwind through early 2017, corresponds to a substantial tightening of monetary conditions in the initial weeks of the initiative, which will ease as currency is replaced. Consequently, based on the IMF's India Quarterly Projection Model, GDP growth is expected to slow in the second half of FY2016/17, before gradually rebounding in the course of FY2017/18. An analysis of sectoral accounts that takes reliance on cash into account leads to similar estimates of growth for fiscal years 2016/17 and 2017/18. It is likely, however, that national accounts statistics, at least in the near term, may understate the economic impact of the cash crunch. Specifically, the impact on the informal economy and cash-based sectors, which are relatively large and have been affected the most by the cash crunch, is likely to be understated because these sectors are either not covered in the official statistics or are proxied by the formal sector activity indicators. Nonetheless, the economic repercussions from the currency withdrawal remain a key domestic risk in India, in part as the near-term adverse economic impact of accompanying cash shortages remains difficult to gauge.

Notwithstanding the near-term economic disruptions, the currency withdrawal and exchange initiative may help secure some long-term gains, particularly if complemented by reforms to strengthen India's formal economy and the financial system. The scope for medium-term gains could span several dimensions:

Fiscal gains- Bank deposits of large amounts (above US$4,000) were expected to attract high scrutiny from the Indian tax authorities and the information obtained as a result of income verification could lead to a durable impact on the tax revenue base. With only about 1 percent of the Indian population paying personal income taxes, the scope for broadening the tax base is clearly large. In principle, unreturned cash could also produce a one off revenue gain for the Reserve Bank of India that can enable an increased dividend transfer to the Government of India. Any such windfall revenue would need to be clearly established, should be only realized once, and should be absorbed prudently and preferably in a nonrecurring manner, for example through greater capital injections to public sector banks.

Banking sector liquidity-The increase in banking system liquidity as a result of the currency exchange initiative has been massive, and it can reduce banks' funding costs and thereby lead to a decline in bank lending rates. With a surge in bank deposits and waning demand for credit, the weighted average lending rate of banks on new loans declined by 56 basis points during November 2016 to January 2017. That said, even though the financial system is expected to weather the currency-exchange-induced temporary growth slowdown, the authorities should remain vigilant to risksin view of the potential further buildup of nonperforming loans, including among private banks and elevated corporate sector vulnerabilitiesand ensure prudent support to the affected economic sectors.

Digitalization and de-cashing-The demonetization initiative can be seen as a follow-up to Indian authorities' strong policy push toward greater financial inclusion. Over the past few years, 250 million previously unbanked Indians have been provided with a bank account, and more efficient customer identification is now in place, including with the rollout of a unique identification number (Aadhaar) and the adoption of know-your-customer technologies. More recently, an important technological milestone was the rollout of the Unified Payment Interface, which is an instant virtual fund that transfers service between two bank accounts using a mobile platform that was accompanied by the roll out of e-payment and point of-sale technologies. While the push for greater digitalization of the economy and the financial system is logical, large gaps in consumer access to digital technologies remain. For example, about 350 million Indians do not yet have cell phones, and only 250 million people own smartphones.

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