Economic Implications of Demonetization

Guest article by Bhavesh Garg from the Liberal Arts department of IIT, Hyderabad

On November 8, with minimal warning, PM Modi’s government announced that Rs. 500 and Rs. 1,000 notes ceased to be legal tender in order to wage a war against black money. The move has been thought of facilitating a crackdown on fake currency, corruption and unaccounted black money. Whether this sudden decision will be a success or failure, only time will tell but it is bound to have some social ramifications along with the economic ones.

To understand these ramifications, we must first look at some of the facts related to the use of currency notes in India. According to a report by 'Cost of Cash in India', India is one of the most cash intensive economies in the world. The value of currency in circulation (M0) as a percentage of GDP in India is 12.04% which is significantly higher than other large emerging market economies such as Brazil with 3.93%, Mexico with 5.32%, and South Africa 3.72%. On the financial inclusion front, Indians above the age of 15 who have used a bank account is less than 35% and the figure gets even worse (less than 10%) when we look at the ratio of people who have used non-cash payment as an instrument.

According to RBI data, the value of total bank notes for the year ending 2015-16 was worth Rs. 16.42 lakh crores out of which the notes of denomination of Rs. 500 and Rs. 1000 was a whooping Rs. 14.18 lakh crores (86% of total). The share of Rs. 500 and Rs. 1000 notes in the stock of circulated currency stands at staggering 47% and 39%, respectively. Moreover, the percentage of Fake Indian Currency Notes (FICN) in the Notes in Circulation (NIC) is 0.0007% making it a less significant and relevant issue of black money. This gives us an idea into the magnitude of the effect this demonetization will have on black money and everyday monetary activities.

Pros and Cons

The bold move to demonetization is expected to bring the black money back into the banks, eliminate the fake currency, and monitor the tax evaders and a move towards a more formal cashless economy.

The present move will give a one-time blow to the black money present in the form of cash while it is well-known that more preferred forms of black money are real estate, foreign currencies, golds, etc. Also, cash which forms a very small part of the total black reflects the ineffectiveness of tackling the bigger problem of black money. In addition, the move only focuses on the stock of unaccounted cash and is not targeted towards the deep-rooted problem that lies in the creation of black money.

With regards to the counterfeit currency, the ban will have a significant impact as their hoarders will have a direct loss of money. Again, this is a one-time strike on the fake currency and given that the new notes does not have any additional security features will again give rise to the same problems once the counterfeiters comes back in business.

Another expected benefit would be that the illegal funding for terrorist and criminal activities will be affected. But again, this will be only for a short period of time till the circulation in the economy returns to normal.

Possible Macroeconomic Implications

The decrease in liquidity as a result of ban will help to ease the inflation in the economy as the consumption will be tilted towards the future. In other words, the decline in purchasing power will reduce the aggregate demand of the economy which will further decrease the overall price level of the economy. It is known that time lags reduce the effectiveness of monetary policy and if the adjustment towards boosting demand is not quick then this might even precipitate into a recession. The immediate reduction in money supply along with decline in the velocity of money will lead to reduction in the price level and output of the economy. This will lead to more hoarding of Rs. 100 notes as people will be unwilling to use them for routine transactions and rather save them for precautionary purposes.

In addition, since currency in circulation is a liability for the central bank ("I promise to pay the bearer the sum of X rupees" written on a currency note), the deposits of unaccounted wealth will decrease the RBI’s liabilities. The increase in deposits may help ease the interest rate in future. On the monetary policy side, reduction in back money will improve its transmission mechanism and thus enhance RBI’s credibility in the long-run, which is crucial in curbing the inflationary expectations to achieve the inflation target. However, in the short-run, the RBI’s credibility and independence will be severely affected. On the fiscal side, the unaccounted wealth above the threshold of Rs. 2.5 lakhs will come under the income tax penalties and if the implementation is effective then this can result in a windfall gain for the government and can provide a huge boost to the fiscal consolidation.

On the fiscal side, the unaccounted wealth above the threshold of Rs. 2.5 lakh will come under the income tax penalties and if the implementation is effective then this will be a huge boost to the fiscal consolidation.

Demonetization will be a good push to move towards the more formal economy in the long-run, however, in the short-run, the informal and unorganized sectors will take a massive hit as these are largely dependent on cash-based transactions. The informal sector accounts for about 45% of the GDP and nearly 80% of the total employment. Another sector that will be significantly affected is the real estate. The decrease in demand for housing will drive the real estate prices down and this may prevail for a longer period of time.

The explanation for introduction of Rs. 2,000 notes such as cost-cutting in printing and saving of time may not be logical in the present context. The issuing of even higher denomination note seems like a futile exercise in the demonetization drive as it will further enable corruption and hoarding of black money.

How Has It Fared Till Now?

Over the last three weeks, a careful examination of the effectiveness gives us a mixed picture. On the positive side, the inflation rate has dropped to a 14-month low of 4.2% and the demonetization would drive it further down. According to latest RBI reports, deposits have increased in the banks however around 58% of the total currency in denominations of Rs. 500 and Rs. 1000 have been deposited and the rest are still with the public. This shows the presence of frictions in the market and the unwillingness of black money hoarders to deposit the unaccounted cash and come into the realm of tax penalties.

On the implementation side, the process of injecting new currency and disbursement is not as smooth as it was expected. All over the country people are seen standing in long queues to obtain legal tender and there are large case of banks and ATMs running out of cash. The demonetization has severely affected the informal sector where daily wage laborers are unable to find employment. According to reports, the country’s top two real estate markets in metropolitan cities like Mumbai and Delhi has already seen the impact. The sales have reduced by half as there are no buyers in the market, with prices starting to decrease.

The Way Forward

While the PM Modi has signaled that this is only one part of the bigger plan and another wave of measures is soon to come to eliminate black money and corruption in India, the key issue lies with the implementation of such strikes. On the positive side, there have been significant decrease in the terrorist activities and violent protests in the Kashmir valley. As with the current demonetization, the withdrawal limit of Rs. 2,000 and Rs. 4,000 from ATMs and banks, respectively, is a very small amount to effectively inject the new currency in the economy.

The true success of the transition lies in the ability of people to withdraw money freely and the banks in disbursing them. With the future prospects on tackling black money and corruption, there is a dire need for a better and simplified tax regime. Goods & Services Tax (GST) can go a long way in helping this cause.

For improving aggregate demand, interest rates should go down in order to boost investment and consumption demand. Also, disincentivizing the creation of black money and dealing in it will rectify the root cause of black money. Although there have been many attempts in the past, such as Pradhan Mantri Jan Dhan Yojana (PMJDY), to improve financial reach to all sections of the economy but still there is a need for a better implementation of policies of financial inclusiveness in the form of institutional reforms, in order to ensure effective implementation.

Disclaimer: These are my personal views. All errors are my own. A shorter version of this article is published in Deccan Herald.

– Bhavesh Garg