NEW DELHI (Reuters) - The negative shock from India’s ban on high-value banknotes will last until the end of March but improved growth next year should fully compensate for the loss, a top economic adviser to Prime Minister Narendra Modi told Reuters.

A bank employee stacks a bundle of old 1000 Indian rupee banknotes to count them inside a bank in Jammu, November 25, 2016. REUTERS/Mukesh Gupta

Bibek Debroy, a member of the government’s main policy think tank, said on Wednesday the “demonetisation” drive would improve the fiscal position and urged the government to spend any extra revenue on public investment.

By outlawing all 500 and 1,000 rupee notes in the surprise Nov. 8 announcement, the government hoped people would deposit illicit or untaxed income into banks, boosting tax collection and incentivising the millions operating in the “shadow” economy to enter the formal economy.

The decision sucked 86 percent of cash out of circulation, forcing millions of people to cut outlays and clog banks in search of money, and leaving businesses struggling to pay wages.

“There is certainly going to be a negative shock in Q3 and Q4 of 16/17, which should be compensated by a positive impact in 17/18,” Debroy said in an interview, referring to the Indian fiscal year that runs until March.

“A whole lot that was informal will become formal and a bit more organised,” he added. “That is a positive externality in the slightly longer term.”

PAIN, THEN GAIN

Most economists predict a short-term hit to economic growth from demonetisation, while the Reserve Bank of India has trimmed its growth forecast for the current fiscal year by half a percentage point to 7.1 percent.

Debroy, however, said it was impossible to quantify the impact, because the government does not yet know how much cash will come back into the system and what it would do with any extra tax revenue.

Some economists have called for emergency fiscal stimulus to stave off a sharp slowdown, but Debroy said the government should instead focus on public investment.

“I don’t like the word fiscal stimulus – even before Nov. 8 there was an issue about increasing investments, both private and public,” he said.

“What we are talking about is greater public investments in the form of creating assets. That requirement existed before Nov. 8.”

Debroy said the political fallout from demonetisation meant the government was now unlikely to meet an April 1 deadline to finalise its crucial nationwide Goods and Services Tax - the largest taxation overhaul in independent India. He said Sept. 1 was a more reasonable target.

Modi needs to clinch a deal with India’s 29 states on the tax, but the last parliamentary session was a washout as the opposition and government squabbled over the impact of his cash crackdown.

Debroy expects the next session, set to begin before the government presents its federal budget in early February, to be more productive, narrowing the risk that GST is further delayed.

“We are all suffering from a bit of myopia because the last parliamentary session was a bit of a mess. It might well be that the budget session would be a bit more productive,” he said.

($1 = 67.8499 Indian rupees)