The demonetization of 500 and 1000 banknotes is a policy enacted by the Government of India on 8 November 2016. The below figure shows the distribution of currency notes denomination by value. It is seen that 86% of monetary value of currency was demonetized. One of the biggest intention of this move is to attack the stock of black money accumulated by tax evasion and other unfair means. 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 their operations and funding to illegal activities will to a halt. Secondly, govt intends to move towards a cashless society. Demonetization of 500 and 1000 rupee notes is expected to make a shift in culture of cash transactions to digital transactions. Cashless society will increase credit access and financial inclusion.
Financial transaction done through the credit card, debit card, net banking and the other source of electronic payments can be monitored by the government and give them the ability to track and stop black money transactions. Cashless is the permanent solution to counterfeit currency which pays a big role in terrorism and smuggling. It also reduces the cost of managing the paper currency. Thirdly, it is expected to 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 government’s liability to that extent. The govt revenues are expected to rise as they will seize the unaccounted money. The bank rates will then go down and will lead to lower interest rates which will lead to increase in consumption levels. Short term effect on economy There will be a disruption in the current liquidity situation as households are likely to get affected by the note exchange terms laid by the government. Though clarity is unfolding on this, commodity transactions and general cash market transactions are likely to feel an immediate impact.
Unorganized sector proceedings, including small trade market activities, will remain volatile in the short-term. It is important to note that a significant percentage of the Indian workforce is employed in this sector, which is likely to be affected by immediate liquidity issues. Overall, negative impact on disposable income is expected along with likely disruption in the consumption patterns of the general populace. It is estimated that there will be a negative GDP impact in the current quarter as consumption gets a shock in the immediate term.
However, quantum and degree of this impact cannot be ascertained now. Long term effect on economy The demonetization is attacking only the stock of black money and not addressing the generation and flow of black money. As the situation normalizes, counterfeiting of the currency will resume as enemies of the state have the necessary resources and technology to print the new currency notes. Cash is only about 6% of the black wealth remaining being in offshore accounts, real estate and gold. Hence the desired effect of bringing back the black money and thereby increase the govt income is difficult to achieve.
Pulling out 86% worth of currency notes out of the system without notice, without adequate preparation & without consulting with the economic experts of the country is sure to have unintended consequences. The Rating agencies such as Moody’s and Morgan Stanley have lowered their forecast for India’s GDP growth from 7. 5% to 6. 5% for this fiscal year and lowered the forecast for next two years. However, at this time it does not look like it will cause a recession or lower growth in the future as the basic economic fundamentals continue to strong.
Effect on Macro-economic parameters It is difficult to estimate accurately the actual effect on macro-economic parameters as no historical precedence of any other country demonetizing its currency on such a large scale, only the countries facing hyper-inflation has done such demonetization. However, it is estimated that the tax rates and interest rates on loans are expected to come down as higher income tax collections arising from better compliance would offer scope to reduce rates over the long term.
Inflation is expected to come down as too little money is chasing too many goods also the unaccounted money in the real estate will be taken out of the system. Impact on rural economy Cash and cooperative banks are the back bone of the rural economy. Debit cards, credit cards, net banking and online transactions that are popular in Urban India are nonexistent in the rural part. The lopsided rural-urban spread of ATMs and bank branches has snuffed out economic activity in rural India, with micro, tiny and small enterprises finding it impossible to get cash in 100-rupee notes for their daily operations.
India’s agriculture sector was expected to have a great year. The rainfall was good after two years of drought and the sector was pegged to grow by about 4% in the current fiscal. Demonetization means that the sector could once again take a hit. Agriculture is a cash driven sector and most of the payments for the purchase of seeds, fertilizers, and tools, as well as for laborer salaries, are carried out in cash. India is currently in the middle of harvesting its Kharif (or monsoon) crops and is soon expected to prepare land for the Rabi crops, which are harvested during spring.
Farmers are finding it tough to sell their produce in the APMC (agricultural produce marketing committee) markets. Therefore, despite a good harvest, there is unlikely to be a significant improvement in rural demand. Impact on Informal Economy In our cash-based economy where close to 83 percent of transactions takes place in cash, a cash deficit is bound to have a paralyzing effect on economic activity levels in the short term. The informal sector accounts for more than 40 percent of India’s GDP and provides employment to close to 80 percent of the labor force.
The developed countries have large portion of their population working in the formal sector and developing countries want their formal sector to go larger. But the sudden push may create job losses on a large scale. The shrinkage of the informal sector is likely to result in a short-term adverse effect as the informal sector is no longer able to employ the numbers that it did. Even though the productivity of informal sector is low millions of people are depended on it for their livelihood. However, as the informal sector shrinks, the formal organized sector is likely to gain market share.
Research is showing that in next two years the share of the formal economy in India could expand from 60 percent to 80 percent. Impact on formal and informal financial institutions As soon as the decision was announced the work load on banks increased multi-fold. Queues in banks are not dwindling after one month and their ability to keep ATM’s running is coming are coming under huge scrutiny. This has greatly affected other banking services such as loan clearances, opening of bank and Demat accounts, check collection, credit card processing, etc. With cash transactions facing a reduction online payments will see a surge in demand.
We can expect a large amount of cash in circulation to be brought within the purview of the formal banking system by way of deposits which will reduce the deposit rates and loan rates. The informal financial sector comprising moneylenders and other institutions such as nidhis, hundis, chit funds, etc. The transactional costs of these institutions are low but the repayment is high. They will have a very hard time exchanging its stock of currency (some of which may well be black money), and may indeed suffer a permanent erosion in its lending capacity.
These institutions are regarded as vile by majority of but many people’s livelihood depends on the capital provided by this sector because the formal financial sector has yet failed to reach them. This will have adverse effect on the livelihoods of people depending on the informal financial sector. Sectoral Impact of demonetization While sectors in the unorganized economy are likely to be affected, technology and financial services are expected to gain. The commodities and agricultural sector, including the market for consumer durables and non-durables is expected to face reduction in demand.
In the short to medium-term, large purchases will likely be made online purchases rather than traditional retail outlets. This will adversely impact the retail sector. The real estate sector is already suffering from reduction in demand as prices remain high and the unsold housing units are piling up will further face downfall as the transaction are made in cash partially or fully. There is an expectation that there will be a revaluation of current real estate transactions across the board.
The luxury goods market is also likely to get affected as this move represents an erosion of real wealth to many people black money or otherwise. Luxury cars, SUVs, gems, jewelry, gold and high-end branded products which are high price goods are also purchased by cash and hence will get negatively impacted On the positive side, customers will acquire their requirements through online transactions such as net banking and paytm wallets. Businesses in the fin-tech sector, including payment banks, mobile wallets, electronic transfer providers, etc. are therefore expected to see gains.