The Impact of Demonetisation


Demonetisation

The Indian Government has discontinued the use of old Rs 500 and Rs. 1000 notes. This decision had become effective from the midnight of 8th November 2016.

The Demonetisation scheme was introduced mainly to unearth black money. 

Black money is a huge concern in India. As per a study by Ambit capital research, black money in India accounts for 25-30 % of GDP amounting to Rs. 30-50 lakh crores, which is larger than real economy of many nations like Argentina and Thailand. (1).

(You can get a basic understanding of Demonetisation from these articles:

  1. Demonetisation of currency explained
  2. Should India make a transition to the cashless economy?)

Though the economic impact of demonetization is still not clear, it is an undisputed fact that the implementation of the scheme could have been better.

The scheme was not planned properly. The policy makers realised that the ATMs should have been recalibrated to dispense the new 2000 notes ( which was of a different size) only after the demonetisation was already announced. Also, the rules related to the scheme had to be changed at least 62 times to accommodate various exigencies.

We will not go into the details of the implementation part in this article. We will just list the negative and the positive impact of demonetisation.

Though we are yet to figure out the long-term economic consequences of the decision, we can gauge the short-term impact.

Negative impact
  • The impact of Demonetisation on black money is questionable. As per reports, the entire amount of money in circulation (including black money) has returned to the banks.
  • In the above context, the Government has argued that even if the entire money is deposited in banks, it does not imply that it has become white. These deposits are yet to be scrutinised by the Income Tax department. But, investigation of such large number of bank accounts is not an easy task. Moreover, it will increase the power of the IT Department which can be used to harass innocent tax-payers.
  • Even after the decision, some people could get their black money in old notes converted to new notes at a commission. According to the IT department, since demonetisation, it has seized Rs. 500 crore in cash of which Rs. 92 crores is in new 2000 notes. (4)
  • As of March 2016, the banned 500 and 1000 notes together comprise 85 % of the total currency in circulation (Rs. 14.18 lakh crore in value). Thus, the demonetisation led to a monetary supply shock in the economy. For this reason, the GDP is expected to slow down. The economists and experts have revised their GDP forecasts downwards for 2016-17.
  • The informal sector in India is largely dependent on cash. The informal sector accounts for 45 % of GDP and 80 % of employment. Therefore, the disruption is costly. It can be detrimental to the economy.
  • Last, but not the least, demonetisation by itself will not have any impact on black money. It has to be accompanied by a structural reform of the economy. Taxation reform is essential. Otherwise, people will find other ways to generate black money.
POSITIVE IMPACT
  • Though growth outlook has been revised downwards, it has not really affected the overall market much and investors believe that the impact is temporary. (Source: Livemint: How much has demonetisation affected the stock market)
  • The property prices in India have gone down by 10-15%. Thus, demonetisation could make affordable housing a reality.
  • The tax revenues of the Indian Government will increase. The tax collections in India is very poor. Only 1% of our total population had paid income tax in 2013. Also, from the year 1991 to 2014, the tax-GDP ratio has remained constant between 16% and 17%. Demonetisation could change that if all the money that has come into the banking system is taxed.
  • Demonetisation has led to a behavioural change by forcing people to adapt to cashless modes of transactions
  • Lending rates have declined. The deposits in the banks have reached record numbers. Therefore, banks like HDFC, Bank of Baroda, Bank of India have cut their lending rate
  • Lastly, demonetisation has hit illegal hawala transactions. Some retailers in India import goods from China. They under-invoiced their imports to save taxes. The balance was paid into the bank account of the seller in Hong Kong through hawala. For instance: If A from India wants to buy goods worth Rs. 100 from a Chinese trader, the import will be billed/ invoiced at Rs. 70. It is done to save taxes. The Indian will have to pay tax on only Rs. 70 worth of imports. The balance Rs. 30 will be sent through Hawala. (2)

Thus, Demonetisation has both positive and negative impact on the economy. It will have to be seen if the benefits significantly outweigh the costs, for the scheme to be deemed successful.

To conclude, we quote Kenneth Rogoff, “In an economy profoundly crippled by tax evasion and corruption, India’s radical demonetisation may yet have positive long-run effects. In a sense, Mr Modi’s broader goal is to change the mindset of India. If followed up with a broad range of actions to fight corruption and to enhance financial inclusion, his monetary revolution may yet succeed. But for now, most Indians can only hope the government will soon have printed enough currency for the country to return to some sense of normality. “(3)

References:

  1. //indianexpress.com/article/business/economy/ambit-capital-black-economy-shrinking-pegged-at-20-per-cent-of-gdp-2835783/
  2. //economictimes.indiatimes.com/news/economy/foreign-trade/china-trade-takes-a-hit-as-hawala-channels-
  3. //www.ft.com/content/59c3e922-bd72-11e6-8b45-b8b81dd5d080
  4. //indianexpress.com/article/opinion/columns/demonetisation-cashless-economy-a-distracting-mirage-black-money-income-tax-department-4443622/

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