Introduction:
Govt of India has demonetized High denomination currency [Rs 500 & Rs 1000]
on 9th November 2016. In this single move, the Government has attempted to
tackle three major issues affecting the
economy i.e. a parallel economy, counterfeit currency in circulation and terror
financing. This study aims at highlighting the effect of
demonetization in the economy and across various sectors.
History:
Demonetization was previously implemented on Jan 1946 and again in Jan 1978.
During 1946, bank notes of Rs 1,000 and Rs 10,000 were withdrawn. And during
1978, bank notes of Rs 1,000, Rs 5,000 and Rs 10,000 were withdrawn.
Apart from India, United
States (in 1969), Sri Lanka (in 1970), Ghana (in 1982), Nigeria (in 1984),
Myanmar (1987), North Korea (in 2010), Libya (in 2012) and Zimbabwe (in 2015)
are some other countries that have demonetized their currency.
Considering the Socio - Economic
and Political aspects, demonetization implemented in India (1978), Sri Lanka
and Unites States of America were compared for the current study.
After
effects of Demonetization:
Liquidity
Squeeze: With demonetization, more than Rs 14.101
Lakh Crores of the Rs 16.40 Lakh Crores in circulation were frozen over night.
This amounts to nearly 86% of the currency in circulation. This is
significantly higher in comparison to the 11.65% and 1.75% currency demonetized
in 1946 and 1978 respectively. Due to which the impact would be wider than
earlier.
Though Rs 1.50 Lakh Crores
have come into circulation as of 25th November, as most of the currency bought
into circulation is in the form of Rs 2000 notes which are not ideal for
transacting, the liquidity crunch continued.
This is expected to ease
out in few months considering it would be few more months before the deficit of
currency in circulation can be covered.
Consumption: India's
consumption basket is cash intensive. Value of cash transactions as a
percentage of total consumer payments was approximately 86% in 2012. Though
these ratios might have improved in the last few years, it is safe to assume
that the share of payments in cash would still be significantly higher than in
other modes.
The contraction in the
cash economy, would lead to a reduced consumption demand in the short-term.
This would further impact the production, employment and growth. However as
liquidity is eased into the system, the same is expected to return to normalcy.
This would be further aided by the use of alternative modes of payment like
digital transaction systems, POS machines, E-Wallets, Apps etc.
Employment: As
per 2009-10 census, India's employment in organised sector is only 16% against 84%2
in the unorganised sector. Though these ratios might have improved in the last
5 years, it is safe to assume that the share of employment from the unorganised
sector would still be significantly higher than that from the organised sector.
The
employment in the unorganised sector (mainly blue collar jobs) would be
impacted in the short term. Recovery of GDP coupled with strengthed formal
sector would not only increase the employment but will also improve the ratio
of employement in Organised to unorganised sectors in the long term. However
Govt does not take any measures to curtain the loss of employment due to
demonetisation, the same might lead to a further drop in GDP.
Capital
Availability: Demonetization will erase a portion of
undisclosed/not-taxed money from the market. Informal lending would shrink
impacting the credit flow to the small and medium players in the unorganized
sectors who typically borrow from this medium. This capital erosion coupled
with the liquidity crunch will affect these players in the Short - Medium term.
However as the funds
available in the banking system would increase, lending to the organized
sectors would improve. This excess capital with the banks would also lead to a
decrease in the interest rates.
Effect
on various Sectors: Sectors where cash transactions play
a vital role would have immediate negative impact. This includes sectors like
Real-Estate, Construction, Jewellery, Agriculture and other informal sectors.
In Real estate, the Luxury market & secondary market (re-sale market) will be hit the worst. However the primary market might recover in the medium term after its correction, as first time buyers may enter the market .
As nearly 80% of its sales are in the unorganised market who deal mostly in cash, Jewellery segment will also be heavily impacted in the short term.
Sectors that have strong dependency on Real-estate like Cement, Steel etc will also face a negative impact in the short run. Tourism would also be impacted. Apart from the above due to the slowdown in discretionary spending, Luxury items, Automobile and consumer durables will also be effected in the short term.
GDP: GDP
would have a negative impact in the short run due to liquidity crunch, reduced
consumption, adverse impact on sectors dependent on the cash economy including
the ones operating in unorganized segments. As captured in the chart below, the
GDP growth has dived during the year when demonetization was implemented in
India (1978)3, Sri lanka3 and USA3. The effect
of demonetization could also be seen in the immediate years.
Though the impact of
demonetization on the GDP growth of USA was evident, it was not as severe as in
India and Sri lanka. India's GDP growth fell from 7.25% to -5.24% before
recovering. Sri Lankan GDP growth fell from 7.72% to -0.41% before recovering.
In comparison to that, USA's GDP growth fell only from 4.80% to 3.10%. As India
and Sri lanka were developing economies with low exports, the impact of
demonetization was severe. Poor monsoon also added to the woes of India during the
period.
However as the liquidity
crunch eases, consumption would improve leading GDP to the previous levels if
not higher. The same could be observed in the upswing in GDP growth after 2-3
years of demonetization.
Inflation: A
drop in demand due to the contraction in cash economy would initially lead to reduced
prices leading to a drop in inflation. However as the drop in production would
meet the eased liquidity (after the GDP improves), the same would increase
inflation to neutralize the earlier fall.
As observed from the above
chart, inflation has dropped in the year of demonetization, only to increase as
the GDP has improved.
Conclusion
& The Way Forward: Though there would be initial
disruptions, the current move can improve the Indian economy by improving the
Govt's Fiscal position, Tax revenues and tax compliance. This would improve the
Govt's ability to spend on Infrastructure projects and other investments which
would create employment and drive growth.
However, if no actions are
taken to stop the further generation of black money, the informal segment would
return to haunt sooner or later. Hence further steps needs to be taken to prevent
the creation of black money in the long run. The Government should also consider
introducing Polymer currency to control counterfeiting currency.
Government should conduct
a digital outreach for on-boarding of the masses (especially from rural areas)
to other modes of payment, there by easing the liquidity crisis in the rural
areas.
Considering the increase
in Tax revenues due to demonetization, Govt should to invest /increase its
investment in the infrastructure projects to drive growth and create
employment. The lack of which will lead to a continued downfall in GDP due to
loss of employment, lower consumption and liquidity crunch.
Considering the drop in
domestic demand, the Govt should help the enterprises in exporting their products.
This would not only help the enterprises stay afloat but also would control the drop
in employment and improve the fiscal position.
Incentives should be
provided in the form of subsidised loans, tax holidays, lower tax rates to
improve disposable income which would drive the consumption there by improving
GDP.
Data Sources:
1: RBI | 2: GOI Census | 3: World Bank | Various news articles
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Mr Chris Priyesh B.
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