The positive effects of demonetisation of Rs 500 and 1,000 notes are unlikely to be of long term nature to support banks’ credit profile, said Fitch Ratings. The rating agency, which reaffirmed its negative outlook on the Indian banking sector, said: “The move (demonetisation) has the potential to raise government revenue and encourage bank lending, but Fitch Ratings believes the positive effects are unlikely to be strong and sufficiently enduring to support credit profiles.”
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“The impact on GDP (gross domestic product) growth will increase the longer the disruption continues, but we will already need to revise down our forecasts to reflect what will almost certainly be a weak 4Q16,” it said. The cash crunch seems to be holding back economic activity with reports about disruption in supply chains.
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, and 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.
“This potentially significant amount would be subtracted from the Reserve Bank of India’s (RBI) liabilities, and the authorities would have the option to transfer this windfall to the government,” Fitch said. According to Fitch, India’s sovereign credit profile would benefit from an improvement in government finances, which currently stand out as a major weakness.
Demonetisation is a one-off event, and 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. On the impact on the banking sector, Fitch said some banks have already reported large increases in deposits since demonetisation began.
“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,” it said. Furthermore, the positive impact on funding conditions will depend on deposits remaining in banks beyond the next few months, said the agency, adding that there is nothing to prevent them being withdrawn again.