By Rafael Nam and Swati Bhat
MUMBAI (Reuters) - India's shock move to take larger bank notes out of circulation will hit Asia's third-largest economy in the short term, but pain will turn to longer-term gains including transparency, higher tax revenues and lower inflation, economists said.
The removal of 500 and 1,000 rupee bank notes to flush out money hidden from the tax man has led to confusion and anger among Indians, who cannot access cash from ATMs and are working out how to preserve the value of what they hold.
That, in turn, will hit consumer demand, as well as sectors long suspected to have been fueled by illicit funds, such as gold and property, where many transactions are cash-based.
Underlining the scale of the gamble being taken by Prime Minister Narendra Modi ahead of key state elections next year, the impact will also be felt keenly in rural areas, where large segments of the population have no formal access to banking.
But analysts said that the effects would be offset as prices, especially in the large real estate sector, come down, raising optimism among bond investors that the Reserve Bank of India (RBI) would be more willing to ease monetary policy.
Some now expect the RBI to make deeper cuts to the repo rate <INREPO=ECI> than expected, after it lowered it by a quarter percentage point last month.
"This is a long-term positive for the debt market and may lead to repo rate cut of 50 basis points," said Murthy Nagarajan, head of fixed income at Quantum Mutual Fund.
Analysts had previously forecast the RBI to cut rates by an additional 25 basis points in early 2017. The central bank holds its next policy review on Dec. 6.
Lower rates in turn could support longer term growth, and are something Modi's government had been pushing for.
Although India is the world's fastest growing major economy, its 7.1 percent expansion in the April-June quarter from a year earlier is still below the 8 percent needed to sustain full employment.
However, much will depend on how the government and the central bank manage the transition, analysts warned, while predictions remain constrained by the lack of formal data measuring the extent of India's "black economy."
"It is a well thought out move that can wipe out the stock of money generated by the parallel economy," said A. Prasanna, chief economist at ICICI Securities Primary Dealership.
"Going forward, key issues will be a smooth transition to the new notes as well as ensuring that the parallel economy continues to be disincentivised."
India's 500 and 1,000 rupee notes comprised 86 percent of the value of currency in circulation, or 10.4 percent of the economy, according to UBS estimates.
After what some analysts are describing as the boldest financial measure taken since the economic liberalization of 1991, those notes will be replaced by new 500 and 2,000 rupee bank notes starting on Thursday.
For the government, increased transparency could yield more revenues. UBS estimated the government could reap an additional $30 billion in taxes, a vital support for a country that has long struggled to contain its fiscal deficits.
"Despite knee jerk reaction in the markets and economy, we believe this step is very positive for government finances, the inflation/interest rate outlook, and long-term GDP growth," Macquarie said in a note to clients.
(Editing by Euan Rocha and Mike Collett-White)