India’s Demonetization Drive

India’s Demonetisation Policy: Benefits and Implications

By M. Taimur Fahad Khan.

Indian Prime Minister Narendra Modi announced the demonetization policy on November 8, 2016 disbanding the old 500 and 1000 rupee notes and replacing them with new 500 and 2000 denomination notes. India has adopted the demonetization policy once before in 1978 under the premiership of Moraji Desai.

Indian society has mixed feelings, reactions and sentiments towards this move but the majority is leaning towards calling it a curse not only for the economy but for the society as an increasing number of people, especially the lower class have lost numerous lives due to the chaos and mayhem being caused by demonetization.

PM Modi termed the move as, “the beginning of deep and continuous struggle against black money.” The Indian janta being overly utopian-minded and a superstitious society credited all the current mishaps and bad incidents over the past two weeks to Modi’s move of demonetization. But staying in the realm of physical and empirical reality where economy and politics are prime determinants of existence and sustainability, the pros and cons of the demonetization have to be weighed against each other with evidence and logic.

The pros of the demonetization move include:

  • Demonetization will cut the supply of black money circulating in the economy and bring a large part of it in the formal economy.
  • Tax gains would improve IF the government is able to exhume the unaccounted cash from black money.
  • Short-term impact on banking sector as withdrawal limit will improve deposits which will enhance liquidity, lower deposit and lending rates accordingly.
  • According to Arundati Bhattacharya, Chairperson State Bank of India, demonetization will lead to lower interest rates.
  • If government successfully encourages alternate mode of payment, it might improve liquidity in the banking system.
  • Food prices are expected to come down due to shortage of cash, related fall in buying and high yield of crops this year.
  • Demonetization will restrict cash circulation as corrupt activities and illegal dealings are done via cash.
  • Civic agencies record a 268% increase in tax collection in the month of November, 2016 (mostly done via demonetized currency notes) which experts believe that the returns don’t reflect improved efficiency in tax collection instead it was a hefty move to get rid of the demonetized currency.

However, the cons of the demonetization policy outweigh the pros. They are as follows:

  • Demonetization triggered massive disruption of cash-intensive areas of the economy, e.g. shopping, food, supplies etc.
  • Growth component of services and goods halve on back of these monetary shocks.
  • Full fiscal year’s GDP to decrease by 0.7-1%.
  • Immediate impact of demonetization on black money could most probably lead to “slower consumption” in formal and informal sectors, especially after the introduction of new goods and services tax next year according to Sanjay Mookim (BAML Research Analyst).
  • Small farmers will experience a direct impact of this policy as all their transactions are in cash.
  • According to Mookim, the services sector which makes up 61% of the national GDP of India will also take a direct hit due to the loss of revenue due to current disruption.
  • Due to orthodox investment strategies and slowdown in the economy, the consumption decline would add to lower growth.
  • Credit will turn negative as this financial crunch will hit sectors like real estate, and construction as they are related to several other formal and informal sectors as well.
  • The negative impact of this crunch will also be borne by the daily/weekly wage employment sector causing a big decline in this employment multiplier sector.
  • CPI (consumer price index – used to calculate inflation) is expected to be dropped by 20 points which would adversely impact the public sector wages according to DBS India.
  • A drop in the CPI would also negatively affect the government, businesses and ultimately a majority of the consumers as well.
  • Shortage of small denomination notes (due to people withdrawing them because of the unavailability of even denomination notes such as 500 and 1000 notes) will and did result in the uselessness of 2000 rupee notes for routine transactions.
  • All groups and segments of the society are hit by this, especially the disenfranchised group.

The main motives behind the demonetization move and the primary targets of this policy were extremely positive and straight-forward, to contain corruption, growth of India’s swelling shadow economy (which is 25-30% of India’s GDP), and to stop the excessive flow of fake/forged currency that is used to fund terrorism. But this policy/move back fired due to multiple reasons.

India’s cash consumption basket is cash-intensive according to HSBC’s Chief India Economist Pranjul Bhandari.  95 percent of the transactions in India are made in cash. The 500 and 1000 rupee notes that were demonetized were the most popular currency denominations of India by value and made up to 86% of the currency being circulated in India, so when they were de-regularised, it had a huge impact not just on the overall economy of India but also disrupted the day-to-day social monetary transactions that resulted in creating a havoc in the society.

The demonetization move was ill-planned and abrupt. India policymakers and economists overestimated the synchronisation between the government and various financial institutions of the country. The government and the banking system were not ready for a move of such gigantic proportions which resulted in such a slow and arbitrary transition. There is also divergence in India’s official money supply and effective money supply (currency used for daily financial transactions) which should have been taken into account.

Demonetization is a smooth process in developed countries like the United States, Germany and United Kingdom since most citizens have bank accounts and possess credit and debit cards (carrying most of their monetary transactions electronically) but in countries like India, banking or even having a bank account is considered a luxury where only 1% of the population is paying income tax.

Demonetization policy failed to achieve its objectives (at least in short term) because it was unsuccessful to touch huge chunks of black money that lie in Swiss Banks which are out of its jurisdiction, instead all the adverse effects are being borne by the middle and lower classes of India. Massive protests are being carried out by the opposition parties and the public in all parts of India. Indian National Congress and Samajvadi Party violently oppose the demonetization move. On November 23, 2016 there was a large protest by 10 political parties of the opposition in front of the Indian Parliament. Several famous politicians, chief ministers and members of Lok Sabha participated in the protest. The former Planning Commission Deputy Chairman Montek Singh in a statement said, “demonetization will pull down GDP growth by 1-2%. Regardless of how much the government is trying to push this move as an ultimate success with greater long term goals, prominent members of the ruling party BJP are also sceptical of the move terming it ‘chaotic.’

Modi in an emotional speech requested the nation for 50 days to launch this self-labelled war on black money and corruption. Demonetization did bring with it an inevitable slowdown but the move could probably be the beginning of a new economy for India. One that is more inclusive, and digitized. The government also enhanced demonetisation relief for the rural sector by asking the national rural bank (NABARD) to sanction Rs 21,000 crores to cooperative banks, making new denomination notes available in 1.5 lakh post offices, doubling e-wallets’ capacity and paving the way for service charge free electronic transactions on ‘feature phones’ too, until December 31.

PM Modi asked the people to make short-term sacrifices in the interest of long-term gains by virtue of all the money that will be seized from hoarders. Both the activist and the non-activist sections of the society have equally raved about or ripped apart this rhetoric. The long term ‘PROS’ of the demonetization policy are all IFS and MAYBES but the short term shock and setbacks of this policy are showing effects and making impacts RIGHT NOW. While it is too soon to declare whether the long-term gains are indeed forthcoming, the “short term” sacrifices have been more than just significant. They have been immensely painful.

In the words of former Indian Prime Minister and chief economist Manmohan Singh, “The government’s decision to recall high-value banknotes two weeks ago was implemented with “monumental mismanagement”. Those who say demonetization is good in the long run should recall Keynes’ quote, ‘In the long run, we are all dead.'”

About Author.

Writer is Research Assistant associated with Islamabad based think tank Institute of Strategic Studies Islamabad (ISSI).

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