Demonetization in India: Rate Hikes and Lower Consumer Spending

Last month we wrote a blog series on Central Banking policy in several regions of the world. One region that was not covered in that series was the second biggest country by population, and the world’s 7th largest economy by GDP; India. India has come into focus in recent weeks as Prime Minister Narendra Modi has called for India to demonetize, particularly calling for a ban on high-value bank notes in an effort to cut down on corruption and tax evasion. This has had several side effects on the Indian economy, most of which seem to be negatively impacting the nation as a whole, and sending India on a path towards cutting interest rates at a time when the US is heading towards possibly a series of rate hikes.

India’s decision to demonetize and eliminate the 500 and 1000 rupee notes has led to difficulties in the spending of money which has pushed inflation down, and ultimately will likely lead to a 1% drop in GDP from the 7.3% growth recorded in the third quarter of the year. This is very substantial and will likely lead to a rate cut of 25 basis points (0.25%) to 6%, according to economists surveyed by the Wall Street Journal. Although overall India’s economy is still growing at a great pace compared to the western developed world, they already missed expected GDP growth in the third quarter of 2016, clocking in at 0.2% below their 7.5% target for annualized growth. Furthermore, the consumer inflation in the country stood at 4.2% in October, which trails the 5% inflation rate that the Reserve Bank of India is targeting for the beginning of 2018. All of these factors will result in a rate cut, as less large bills circulate in India, an overwhelmingly cash based society, the consumers will have less money to spend thus lowering growth and inflation. To summarize, the slowing growth and inflation will lead to the Central Bank undergoing at least 1 rate cut if not more in the future.

It remains to be seen if Narendra Modi’s plans to eliminate the most valuable bank notes will prove economically or socially viable for India. One thing that is known, however, is that the banning of high value notes will directly reduce inflation numbers, overall consumer spending (and thus GDP growth), and likely require a rate cut to stimulate spending and growth. Time will tell if the reduction in tax evasion and corruption will be worth the economic consequences the country faces as a result of the decision.