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We return from India where the economic and policy discussion is still, unsurprisingly, dominated by the demonetisation of the economy. The move to scrap all 500 and 1000 rupee notes, approximately 86% of all banknotes in circulation, seems certain to impact negatively on growth but the extent is still the subject of widespread debate.

Much will depend on the rapidity of the rollout of replacement banknotes, the willingness of households to use cashless forms of payment, and the fiscal bounty (if any) which accrues to the government from amnesty taxes and transfers from the central bank – though for now no such transfer is planned.

Little data is available so far (though third quarter GDP was not encouraging, even before this policy), but the purchasing managers’ index (PMI) release showed a sizeable immediate impact to the services sector.

Central bank focused on inflation risks

In general, the expectation was that the growth and inflation impacts of the policy would compel the central bank to ease more aggressively, with most seeming to expect 100 bps of cuts by the end of 2017.

Consequently, the decision earlier this week to keep rates on hold by the Reserve Bank of India (RBI) was something of a surprise. It certainly seems that the RBI has a much less pessimistic view of the growth impact of the demonetisation policy than the market. Private sector estimates put GDP between one and four percentage points (pp) lower for the fiscal year as a result of the policy, whereas the RBI expects a drag of just 0.15 pp.

Meanwhile, on inflation, the RBI remains concerned that the trajectory is less favourable than envisioned by the market. Base effects will lead to higher prints in December and February, oil prices are rising, and core inflation is proving sticky. With a smaller downward growth revision than private sector economists, a decision to hold rather than cut is therefore unsurprising. But if the RBI turns out to be overly optimistic on the growth numbers, a change in policy could come about relatively quickly.

Government still enjoys support

Beyond demonetisation, opinion of Prime Minister Modi’s government seems to remain relatively positive. We detected perhaps more realism than on past visits, and an acceptance that reforming India’s economy is not an easily accomplished task. Still, the ‘Make in India’ initiative seems to be more style than substance at present and is not doing much to foster investment and local manufacturing, beneath the headlines.

This is perhaps reflected in the third quarter GDP numbers which showed a deeper contraction in investment, of -5.6% y/y, from an already poor 3.1% contraction in Q2. The share of investment in GDP has been falling since the end of 2015 and now stands at just under 29%, compared to a little under 33% when Modi won power.

As a result, growth is increasingly reliant on a mix of consumption and government spending, which is what makes the demonetisation policy such a threat to growth in an economy with a large informal sector (45% of GDP) and reliant on cash for transactions.

Uncertainty over implementation of tax reform

Unfortunately for Modi, the demonetisation policy seems to have temporarily derailed the Goods and Services Tax. A banner reform, its much delayed passage had been a cause for celebration. Some states are worried that demonetisation will adversely impact the revenues from the new tax and so have pushed back against the April implementation deadline. It now seems that the earliest date for this long-awaited change has been postponed once more, to Q3 2017.

Uncertainty over tax policy can only further weaken investment demand and state government spending, so this adds to the downside risks for India. We find ourselves having some sympathy for the view that the demonetisation policy was not fully planned or considered, and Modi is now paying the price.