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India economic growth to slow dramatically after cash crunch

Once again, India has revealed data that upholds its ranking as the world's fastest-growing economy. But the South Asian giant may not able to retain that title for long as a cash squeeze engineered by Prime Minister Narendra Modi's government looks set to hit growth in the coming quarters.

Shops temporarily drew their shutters down to support the anti-demonetization protest on November 28, 2016 in New Delhi.
Saumya Khandelwal / Hindustan Times / Getty Images
Shops temporarily drew their shutters down to support the anti-demonetization protest on November 28, 2016 in New Delhi.

Gross domestic product (GDP) in the July-September period, India's fiscal second quarter, expanded by an annual 7.3 percent, official data revealed on Wednesday. It was an improvement from the previous quarter's 7.1 percent increase, which marked a 15-month low, and eclipsed China's 6.7 percent growth during the same period.

But that may be the last above-7 percent growth reading for some time to come.

"The improved growth is no cause for cheer going forward, since consumption, the main growth driver of the economy, will likely be the biggest casualty in the months ahead as demonetization takes its toll on overall consumption, especially in rural areas," Société Générale economist Kunal Kumar Kundu explained in a Thursday note.

A controversial plan to swap all 500 and 1,000 rupee notes—a combined 86 percent of currency in circulation—with new notes has produced a nation-wide cash crunch amid a limited stock of script.

As a result, consumers are holding off from spending as cash is removed from the system, with a daily limit on the amount of old notes that can be exchanged. Private consumption accounts for a whopping 60 percent of GDP so the frugal mood can have weighty economic consequences.

Launched on Nov. 8, Modi's program is aimed at catching tax evaders holding undeclared cash, or "black money." But so far, the program has mostly hit the lower income population segment, many of whom operate entirely on cash and lack bank accounts to exchange old notes, resulting in nation-wide protests on Monday.

"The sectors most concerning are the ones with a high reliance on cash transactions, which can range from daily foodstuffs to big-ticket items like jewelry and real-estate. So these sectors are likely to feel the crimp in demand over the near term," Shilan Shah, India economist at Capital Economics, told CNBC's "Squawk Box."

The spending hit isn't limited to just consumers, however.

Liquidity shortages in business sectors will also contribute to the looming GDP slowdown, noted Faraz Syed, associate economist at Moody's Analytics. Firms will likely re-calibrate their working capital and delay investment decisions, he told CNBC's "The Rundown."

In anticipation that the demonetization effect will trickle down into the March and June quarters next year, Moody's has now lowered its 2016-2017 growth forecast to 6.6 percent from 7.5 percent previously.

The falling growth combined with an expected drop in inflation, due to a healthy monsoon season and declining food prices, should motivate the central bank to cut interest rates by 25 basis points at its scheduled meeting next week, Syed said.

While Capital Economics' Shah agrees the economy will set to take a beating in the upcoming quarter, he warned that India's growth data needs to be taken with a pinch of salt. "Demonetization aside, the other major caveat when it comes to India GDP is accuracy... The economy is likely growing a few percentage points slower than what official data suggests."

Indeed, many remain skeptical of New Delhi's new GDP calculation method that was introduced in January 2015.

Until the government unveils more clarity on the methodology, analysts and policymakers will look at alternative indicators, such as monthly manufacturing data, to gauge economic health, Shah noted.

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