Demonetization and its impact on Indian Economy

The author in this article discusses the impact of demonetization on Indian economy with its pros and cons. It also discusses how in the short term, almost all regions of India resulting in the lack of cash has adversely affected the economy. However, in the long run, the informal economy will be formalized.

Demonetization: A Shock to India

On Nov. 8, 86% of India’s currency was nullified in a great demonetization effort that aimed to clean out the black market’s cash supply and counterfeit notes which completely disrupted the social, political, and economic spheres of the world’s second-largest emerging market. All 500 and 1,000 rupee notes were instantaneously voided, and a 50 day period ensued where the population could (ideally) redeem their canceled cash for newly designed 500 and 2,000 rupee notes or deposit them into bank accounts. India has done this before. In 1946, all 1,000 and 10,000 rupee notes were recalled. In 1978, 1,000, 5,000, and 10,000 rupee notes were demonetized.

This recent bout of demonetization was planned in secret by a small, tight-knit group led by Prime Minister Modi, and it overtook the country like a flash flood. This surprise was by design, as it was feared that if the black market caught wind of what the government was planning they would find ways to rapidly unload their illicit cash, and the initiative would flop on one of its initially-stated goals.

Of course, this meant that the rest of Indian society was also caught in the demonetization crossfire. Not even the banks — that would be required to do the heavy lifting on the ground — were in the loop. In the days following Modi’s announcement, the banks didn’t have enough of the newly designed banknotes on-hand to distribute in exchange for the canceled notes, and there simply wasn’t an adequate supply of smaller denominations in circulation to run the cash economy. Far from being a 50-day transition, it is estimated that even if India’s printing presses were to run 24/7 it would take upwards of four months to a year before the currency supply was adequately restored.

Some of the impact generated by the demonetization are-

Black Money

Black money stored in the form of Rs 500 and Rs 1000 notes will be taken out of our system. As predicted by ICICI Securities Primary Dealership the government’s plan to scrap Rs.500 and Rs.1,000 notes will uncover up to Rs. 4.6 lakh crore in black money.

Terror funding

Fake Indian Currency Notes (FICN) network will be dismantled by the demonetization measures. Taking out 500 and 1000 rupee notes out of circulation will have a lasting impact on the syndicates producing FICN’s, thus affecting the funding of terror networks in Jammu and Kashmir, North-eastern states, and Naxalite hit states Real estate may see a significant course correction

The demonetization decision is expected to have far-reaching effects on real estate. Resale transactions in the real estate sector often have a significant cash component as it reduces the incidence of capital gains tax. Black money was responsible for a sharp appreciation of properties in metros; real estate prices may now see a sharp drop. Political parties in crisis ahead of polls

With nearly five state elections in 2017, demonetization has stunned political parties. Especially, in large states like Punjab and Uttar Pradesh, cash donations are a huge part of “election management”. In one stroke, big parties will find themselves hamstrung as cash hoards are often undeclared money. Parties will have to completely rejig campaign strategies in light of expected cash crunch.

Moving towards digital payments

Demonetization will likely result in the adoption of virtual wallets such as Paytm, Ola Money etc.: This behavioral change could be a game changer for India.

Temporary chaos and confusion

The public will face minor problems for a few days owing to the scarcity of lower denomination notes in the system.

Merits

One of the biggest benefits of this move is that it is going to drastically affect the corrupt practices. People who are holding black money in cash will not be able to exchange much as they would be in a fear of getting penalized and prosecuted by the authorities. Enemies of the country which are involved in counterfeit currency and terrorism will not be able to continue it further for quite some time at least. The smuggling of arms and dealing with the terrorist will not sustain further as all of the money will be on record now. Secondly, the banking system will improve as it will slowly head towards a cashless society. A cashless society will increase credit access and financial inclusion. The existing white money of people will be known to the government and it will remain with banks so that it can be put on loan, and interest can be generated from it (though interest rates would fall) with a corresponding fall in Inflation. Further Banking System will get a boost, as more than Rs 7-8 lakh crore base money (new legal money) will enter the system. However, it needs to be seen how much money actually remains in the system, once the cash withdrawal limits are eased. Thirdly, it will reduce the risk and cost of cash handling as soft money is safer than hard money. It will also reduce government liability. Since every note is a liability for the government, the old currency will become worthless for those people, who choose not to disclose their income. Thus, this will extinguish the government’s liability to that extent. It is expected approximately Rs 5 lakh crore may come to the government in the form of extinguished RBI liability, taxes, and penalties. This amount is enough to take care of India’s entire fiscal deficit for one year or more.

Demerits

The liquidity squeeze caused by demonetization will be negative across sectors with a high level of cash transactions. Real estate, jewelry, retailing, restaurants, logistics, consumer durables and luxury brands, cement and some segments in retail/SME lending space will be facing short-term instability. Those companies with a high level of debt will face more pressure and can face loan defaults. Secondly, there will be added replacement costs of currency. We cannot ignore the increased cost of operating ATMs need to be refilled more often and also it will be a huge burden on banks. Initially, it is very difficult to create a cashless society as more than 50 percent of the Indian population is not well versed with card transactions. Also for these initial months, it will be very difficult to make cash transactions of a higher amount. But the government is taking steps to improve liquidity into the system and reduce inconvenience as much as possible. India is certainly going to experience “Acche Din” in Modi’s regime. The decision of this surgical strike on black money was not taken in a day or two. Rome was not built in a day and similarly, this plan is the result of the Prime Minister’s meticulous planning and never-ending the fight against corruption. As a result, he has successfully made the right stroke at the right time. Further, the penal provisions are hefty enough to ensure that corrupt practices will find it hard to take roots again. Despite certain short-term troubles, demonetization is certainly going to give a boost to the Indian economy in the long run. As of now, all of us should stand and support this bold move of our Prime Minister and help those needy, around us.

Conclusion

Initially, the purpose of the government was to curb black money, but from the figure it can be concluded that only 97% of rs.500 and rs1000 banknotes were deposited in banks and only 3% of the black money is scraped as undeclared income. Therefore Taking action is ineffective in controlling black money.

However, the tax-GDP ratio will increase in the future. For a while, we stopped transferring the counterfeit currency in the market, but in the long run, the ability to create a duplicate of a new note will never stop. Though in the short-run it can slow down in the long run, it can rebuild the market and easily handle Rs 2000 Bribes instead of the 1,000 rupee banknotes in the briefcase. We must be vigilant and considerate to maintain our growth to sustain demonetizations. In the short term, almost all regions of India resulting in the lack of cash has adversely affected the economy. However, in the long run, the informal economy will be formalized. Therefore, the government needs to focus on the informal economy and create appropriate strategies for them.

Also read Demonetization as Utilitarianism