Three months have passed since the Government of India took the decision to demonetise Rs.500 and Rs.1000 currency notes. This historical decision of ‘Demonetisation’ instantly removed approximately 86% of the cash circulating in the economy. To replace the outgoing currency notes, the RBI released new Rs.500 and Rs.2000 currency notes.

The government took this decision to crackdown on black money that is hoarded in the form of cash, and to eliminate counterfeit currency notes that were circulating in the system. In addition, currency demonetisation was expected to help the government check terrorism and drug trafficking, as illicit money often flows into the hands of terrorists and drug traffickers.

Now that three months have passed and we are beginning to see the effects of demonetisation on the economy, here is my analysis of the developments so far and my expectations for the future.


Digital Payment Services to Get a Boost

The idea of a less-cash economy got a big boost from the government’s decision to demonetise. It nudged people towards alternative payment platforms, such as cheques, plastic cards and other new-age digital mediums like payment banks, mobile wallets and mobile payment applications. The government has touted this transition as one of the brightest outcomes of demonetisation, which could pave the way to a less-cash economy. To help the country progress further on the path to a less-cash economy and to alleviate the short-term cash crunch problem, the government introduced various incentives like waiving off service tax on card payments of up to Rs.2000, and introducing discounts on payments done through electronic means for petrol and diesel, suburban railway tickets and insurance policies bought from state-owned insurance companies.

Moving towards digital transactions has the potential of being one of the most effective solutions to fight black money. However, in a country where a fourth of the population cannot read and write[1], and where a small portion of the educated population can use computers; there is perhaps a very long way to go before digital payments become commonplace. Moreover, security remains a major hurdle in the widespread use of digital payment methods. A lack of proper mechanisms to prevent cyber fraud and redress cybercrime complaints often deters people from using digital payment methods and makes them more skeptical about these methods.


Cash Crunch to Impact Key Sectors

Agriculture Sector

The inability to get a fair price for their crops could affect farmers’ ability to repay their loans.

Demonetisation is expected to have deep impact on the farming community. The paucity of cash with crop buyers made it hard for farmers to get a fair price for their harvest in the days after the demonetisation policy was announced. This came as a huge setback to farmers who were hoping for better earnings this year, given a good monsoon that led to a good crop after two drought years. On the other hand, farmers also found it difficult to buy seeds and fertilizers for the sowing season as cash was in limited supply.

With a decline in farmers’ ability to repay their loans, banks could witness a rise in their NPA’s.

The inability to get a fair price for their crops could affect farmers’ ability to repay their loans. This is especially true of farmers who take seasonal loans to sow their crops and depend on revenues from the same crop to repay these loans. With a decline in farmers’ ability to repay their loans, banks could witness a rise in their NPA’s.

Small Businesses

Transactions in small businesses and shops mostly take place in cash – be it buying supplies or receiving payments from customers. Demonetisation adversely affected the entire business cycle of these establishments, as scarcity of cash stalled transactions. As transactions dwindled, small businesses suffered severe losses.

These enterprises will have to either move to other transaction methods or wait for cash to be abundantly available in the system. In either case, it will take at least a few months before things return to normal for small businesses. However, demonetisation is also expected to force these businesses to enter the mainstream economy, which can result in the broadening of tax base.

Construction and Real Estate

Since real estate is seen as an easy avenue to park black money stashed in the form of cash, the short term cash crunch has severely affected the demand for real estate. The fall in demand has put further pressure on the real estate sector that is already in a slowdown. It has also reduced the speculative buying in the real estate market. Demonetisation led slowdown in demand could result in a positive transformation for the sector from an investment driven sector to a consumption driven sector. Rationalisation of real estate prices is good news for home buyers who found it difficult to buy a house earlier. Reduced speculation would result in prices being driven by consumption demand rather than speculative demand.

But there is also a flip side to this story – Lower prices result in lower profit margins for the real estate developers. This might slow down the number of new construction projects being undertaken in the short run, leading to a slowdown in construction industry.

Automobiles

Demonetisation did not have much of an impact on four-wheelers sales but it has affected sales in the two-wheelers segment, which are heavily dependent on cash sales. Fall in the income of farmers and small businesses is also expected to slowdown sales in segments such as tractors and other commercial vehicles. This could bring a short-term slowdown in the automobile sector.


Economic Growth Under Pressure

Increase in unemployment

Agriculture, construction and small-scale businesses are the largest employment generators in the country[2]. Most people employed in these sectors are from the economically weaker sections of the society and in many cases, are daily-wage labourers or seasonal workers. They usually do not have bank accounts, and therefore, the payments made to them are in cash. The limited availability of cash with their employers and a resulting slowdown has led to difficulty in payment of wages to the workers. Since the payments are made on a daily or weekly basis, the inability to compensate the workers has led to unwillingness among workers to work. This has forced the workers to return to their home towns in the absence of income and enduring expenditures. This can cause a short-term increase in the unemployment levels in the country and cause distress to the workforce.

Dampening economic growth

Rural consumption has been growing over the past few years and has been one of the drivers of India’s economic growth in a time of global economic turbulence. Most of the transactions in the rural economy are cash-based. A majority of India’s population lives in rural areas, and therefore, rural economy is an integral part of the overall economic development. But with agricultural and labor incomes getting affected by demonetisation and there being a reduction in cash in circulation; the rural economy is expected to slow down. Given that the rural economy was expected to spearhead India’s consumption spending, a slowdown in the rural economy could significantly affect India’s growth prospects.

International Monetary Fund (IMF)[3] revised down its GDP growth projections for FY17 by one percentage point due to the expected slowdown in consumption and business activity caused by demonetisation. Several economists have also predicted a slowdown in the economic growth of the country due to demonetisation.


An Unfavourable Cost Benefit Equation for the Exchequer

The cash circulating in the economy is a liability for the RBI, as the central bank is liable to compensate the bearer of the currency for the value that the currency note represents. So, the amount of cash that would not have come back into the system would have resulted in the reduction of liability for the central bank. This reduction could have been shown as gains in the RBI accounts and given to the government in the form of dividend. The government could then have used this amount to provide stimulus to the economy.

The government expected around three to four lakh crore rupees to not come back in the system. But by early December, approximately 80% of the cash was back in the banks and there are no numbers yet to suggest how much counterfeit currency got back into the system. Therefore, the realized gains by the government might not match the expected gains.

The expected cost of printing the currency is Rs.6,100 crores.

Moreover, we must consider other costs involved in this exercise. Bharatiya Reserve Bank Note Mudran Private Limited (BRBNMPL), a wholly owned subsidiary of the Reserve Bank of India, which prints the currency notes for the RBI, in response to an RTI enquiry told that it charges RBI Rs.3,090 for printing 1000 notes of Rs.500 and Rs.3,540 for 1000 notes of Rs.2,000. This brings the expected cost of printing the new currency notes above Rs.6,100 crores excluding transportation or any other costs.

According to CMIE,  an estimated 458 million man-days might have been wasted standing in queues.

There was also a cost involved when people stood in the queues to get their old currency notes exchanged for new ones. Since people were forced to stand in queues, they effectively lost wages for that period. According to a CMIE report[4], an estimated 458 million man-days might have been wasted standing in queues. And the cost of this exercise works out to be Rs.150 billion.


Conclusion

A large proportion of the country’s population either does not have a bank account or does not use them, and are heavily dependent on cash for day to day transactions. Also, majority of the working population are employed in sectors that are cash dependent.  Therefore, the cash crunch caused due to demonetisation caused a slowdown in the country’s economic activity and might continue to do so till there is sufficient cash available in the system.

The slowdown in the economic activity in the short run is expected to increase unemployment and cause a potential loss in tax collections due to losses incurred by businesses. This could be a huge setback for an economy on the verge of major economic developments. But there are also some positive outcomes from this exercise such as the move towards digital means of transactions and broadening of tax base.

However, the question that remains is whether the decision of demonetisation achieved its intended goals of flushing out black money. Preliminary estimates suggest that most of the cash might come back in the system and there are still no numbers on how much counterfeit currency has come into the system. This will mean that demonetisation has underachieved than its expectations. With all the costs involved and the anticipated loss to the economy, it might turn out to be a rather costly and futile exercise.

  

Author:

Sahil Sharma

[email protected]


References

[1]  Consensus 2011: Literacy rate and level of education

[2]  Employment by Sector-Industries, data.gov.in

[3] “World Economic Outlook Update”, IMF, January 2017

[4]“ Cost of queues to exchange currency is an estimated Rs.150 billion”, CMIE, November 2016


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The views presented in this publication are exclusively of the author, and may not reflect Anplify’s views.

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