Why India's demonetisation benefits won't support banks' credit profiles

Uncertainties offset the positive effects.

The demonetisation of large-denomination bank notes has caused short-term disruption in India's economy. The move 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.

Here's more from Fitch Ratings:

The withdrawal of bank notes - that account 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 fertiliser for the sowing season.

Time spent queueing in banks is also likely to have affected general productivity. The impact on GDP 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.

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.

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.

India's sovereign credit profile would benefit from an improvement in government finances, which currently stand out as a major weakness. However, 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.

There are similar uncertainties over the impact on the banking sector. 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.

Reduced lending rates could encourage stronger credit growth, supporting the economy. Lower debt-servicing costs might also speed the resolution of banks' asset-quality problems.

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. Finally, there are other factors holding back lending, most notably the under-capitalisation of state-owned banks and weak investment demand. Fitch today reaffirmed our negative outlook on India's banking sector - notwithstanding the effects of demonetisation - which reflects the fragile standalone position of state banks and the risks to their viability ratings in the absence of larger capital injections.