'Demonetisation to up revenue,may not support credit profiles: Fitch Rating

Demonetisation has caused short-term disruption in economy but if it continues for longer period, there will be impact on GDP growth, says Fitch rating

Fitch Ratings on Tuesday said the demonetisation of old Rs 500, 1,000 notes will raise revenue for the government but warned that the positive effects of the move are unlikely to be strong and long-lasting to support credit profiles.

It said the demonetisation of notes has caused short-term disruption in the economy but if it continues for longer period, there would be impact on the country's GDP growth.

"The move has the potential to raise government revenue and encourage bank lending, but we believe the positive effects are unlikely to be strong and sufficiently enduring to support credit profiles," Fitch said in a report.

The Centre on November 8 announced to demonetise old Rs 500 and Rs 1,000 notes in a fight against black money, fake currency and corruption.

It said the withdrawal of bank notes, accounting for 86% of the value of currency in circulation, has created a cash crunch, and seems to be holding back economic activity.

"Consumers have not had the cash needed to complete purchases, and there have been reports of supply chains being disrupted and farmers unable to buy seeds and fertilisers for the sowing season. Time spent queueing in banks is also likely to have affected general productivity," Fitch said.

The ultimate aim of the note withdrawal was to curb the use of black money, which is in line with the government's broader reform agenda. The informal sector is very large in India, accounting for over 20% of GDP and 80% of employment.

"The move could boost government revenue to the extent that demonetisation helps to move economic activity from the informal to the formal sector, as more earnings would be declared. It is possible that this positive effect would soon outweigh the drag on revenue collection from lower short-term GDP growth," Fitch said.

Government finances may also benefit from a proportion of high-denomination notes not being traded and India's sovereign credit profile would benefit from an improvement in government finances, which currently stand out as a major weakness.

It said with black money not returning to the system, this potentially significant amount would be subtracted from the Reserve Bank's liabilities, and the authorities would have the option to transfer this windfall to the government.
Fitch, however, said there are considerable uncertainties

over the potential positive effects. Most importantly, demonetisation is a one-off event.

"People that operate in the informal sector will still be able to use the new high-denomination bills and other options (like gold) to store their wealth. There are no new incentives for people to avoid cash transactions. The informal sector could soon go back to business as usual," it said.

Fitch added that a surge in low-cost funding may remove a constraint on banks that prevented lending rates from keeping pace with the RBI's policy rate cuts in recent years.

However, demonetisation could also affect the ability of borrowers in sectors that rely on cash transactions to service their loans, with negative effects on bank asset quality, which is why the RBI has temporarily allowed banks to give small borrowers more time to repay loans before classifying them as non-performing.

Furthermore, the positive impact on funding conditions will depend on deposits remaining in banks beyond the next few months. There is nothing to prevent them being withdrawn again, it added.