Decoding structural changes of Demonetization on Indian economy
Kalpesh Desai (Partner, BMR Advisors LLP)
Dipesh Jain (Senior Vice President)
Nilisha Jain (Senior Associate,BMR & Associates LLP)
Mere pyare deshwasio - from our Honorable Prime Minister, Mr Narendra Modi, will no longer be taken lightly by 1.25 billion Indians or as he calls them - savasau karod deshwasi.
With the menace of corruption, black money, fake currency and terrorism at its pinnacle, the Prime Minister, in one of his biggest moves startled the countrymen by demonetizing the existing Rs 500 and Rs 1,000 currency notes overnight, coupled with the announcement to introduce new Rs 500 and Rs 2,000 notes. Heaps of the old currency would become redundant if not converted or deposited with the banking channel and brought in the mainstream economy in the next couple of months, as mandated by the Government. If news reports were to be believed, there have already been instances where people have offered “old” money to various rivers in the country and some have offered to the god of fire, Agni to get rid of any further complications.
As per RBI’s annual report for the financial year 2015-16, the two denominations ie Rs 500 and Rs 1,000 currency notes accounted for nearly 86% of all banknotes in circulation[1]. Knowing how common the use of higher denomination currencies have been, especially in the parallel economy, our article discusses the major structural changes which could be seen in the economy as a whole including possible impact on black money, fake currency and corruption.
Structural changes in economy as a whole
Penetration of cashless mode of payment is very low in India and a large chunk of the population, especially at the bottom of the pyramid and the rural population where banking facilities are extremely low, still depend on the hard currency and seem to be the most hit. From a short term perspective, while the existing notes have been banned overnight and circulation of new notes is yet to spread widely across the nation, the immediate impact will be sensed amongst these people. Besides, certain sectors necessitating frequent use of cash on a daily basis including hospitals, households, roadside vendors, domestic workers, cab drivers, doctors, transporters, are also likely to face interim disruptions. In this prime season of harvesting, farmers would face financial difficulties to pay daily wages to laborers in smaller denominations and manage other farming expenses including purchase of seeds and fertilizers, hampering the agricultural produce. Also, with slowdown in consumer spending due to limited availability of cash, the demand for agricultural produce is likely to drop. Similar could be the impact on the MSME sector which is largely run by and caters to the bottom of the pyramid and rural population.
Undisputedly, over medium to long term, impact of demonetisation is expected to be prominent in cash-heavy sectors such as luxury goods, real-estate, gold / jewellery. It is said that a significant portion of property value is paid in unaccounted cash in the real estate sector, which has caused sharp appreciation of property values in metros. The move may now result in downward revaluation in the real estate, and the industry is likely to face the biggest hit as a result of demonetisation. In the interim, construction is also likely to slow down and hence, cement and steel industries are likely to suffer. Also, the overall demand of jewellery and luxury goods may decline, as these involve material cash transactions and also with limited cash availability, the society would rather spend on daily necessities than on jewellery and other luxurious goods. The impact may also be seen in politics and elections which are primarily cash driven. On the other hand, online payment platforms will emerge as winners and should notice substantial increase in the volume of transactions on their platform.
Though there would be certain short term disruptions, the long term benefits seem brighter. As envisaged, black money should be unearthed and deposited in banks, which hopefully should lead to higher collection of direct and indirect taxes. This should indeed have a positive bearing on Governments’ fiscal deficit. Further, there is a possibility that some cash is not deposited with the banking channel, for various reasons, which will reduce the liability of the RBI and could result in huge surplus for the Apex Bank. Separately, the fear of high costs associated with tax evasion should lead to higher tax compliances in the future which could also lead to reduced overall tax rates by the Government. Also, while banks are expected to see large cash inflows, the liquidity and lending appetite of banks should increase facilitating reduced interest rates. Inflation is also expected to fall as a result of decrease in overall consumer demand and reduced interest rates which in turn is expected to strengthen the currency marginally. The biggest benefit would be realized if parallel economy to a great extent consolidates with the main economy, as targeted by the demonetisation move.
Black money
Though demonetisation drive has resulted in whooping increase in cash deposits at banks, what is noteworthy is that this move is only expected to impact those who presently are in possession of unaccounted cash. The dilemma is that it does not seem to affect that part of the stock of black money which has been invested and held in other forms of assets like benami properties in land and real estate, gold, diamonds, precious gems, foreign currency, artifacts, paintings, etc. Secondly, the move may result in increase in the proportion of other assets in which black money is held, with different level of difficulties and challenges to trace the same.
Demonetisation being one of the most known methods to tackle the menace of black money, Government has implemented this move time and again, albeit this time with an element of surprise. Each initiative of the Government has resulted in reducing the stock of black money to some extent in short term. However, gradually with passage of time, stock of black money has been regenerated in the economy. Demonetisation may succeed in reducing the quantum of black money for certain period of time, but the thought that warrants attention is whether there is any way to prevent the generation of black money again and not re-enter the system?
Further, it should be noted that while regeneration of black money is always a possibility, this overnight move would have created a psychological impact on the society at large, who will definitely reconsider before indulging into this practice again. Also, greater level of scrutiny at various levels and digitization coupled with sharing of information between various departments of the Government would help to keep a check on the parallel economy…. not to forget the introduction of Goods and Services Tax which could also play a key role to keep the checks and balances.
Fake currency
Another objective underpinning demonetisation is to make an effort to crash the supply chain of Fake Indian Currency Notes (FICN), alleged to be used for funding anti-social elements like terrorism, smuggling, human trafficking, child labour deals, etc in India. The measure should dismantle the FICN network and bring about an abrupt halt in terror financing activities owing to lack of currency – but for how long is a key question?
Corruption
Indeed the parallel economy or shadow economy based on black money and counterfeit currency has been primary driver for rising level of corruption. Where demonetisation outcome is as desired in the areas to curtail black money circulation and wipe out fake currency, the bold move should positively work towards the initiative to create a \"corruption-free\" India as well. Not complete eradication, but contraction in existing corruption level over the coming years seems likely.
[1] https://rbidocs.rbi.org.in/rdocs/AnnualReport/PDFs/0RBIAR2016CD93589EC2C4467793892C79FD05555D.PDF