India likely to witness a weak Q4 on adverse demonetization effects, says Fitch Ratings

The Indian economy is expected to witness a weak fourth quarter, following adverse effects of demonetization that affected the informal sector in a large way. The demonetization 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. The impact on GDP growth will increase the longer the disruption continues, Fitch Ratings reported.

The move could boost government revenue to the extent that demonetization 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.

Further, the country’s sovereign credit profit will also benefit from the historic move. However, there are considerable uncertainties over the potential positive effects. 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.

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 There is nothing to prevent them being withdrawn again.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-capitalization of state-owned banks and weak investment demand.

"Fitch today reaffirmed our negative outlook on India's banking sector - notwithstanding the effects of demonetization - which reflects the fragile standalone position of state banks and the risks to their viability ratings in the absence of larger capital injections," the report said.