Demonetization and its impact on Indian Economy

When developing countries have issues with people evading their taxes or even taking part in illegal monetary transactions, demonetization is a popular mechanism used to help curb them. Demonetization is the withdrawal of currencies or other valuables by the central bank to be used as the legal tender in the nation. Such currencies either turn into scrap or deposited in the banks and replaced by the new currencies. 

Governments of many countries across the world have taken this drastic measure to curb black money and stop the counterfeiting of currency notes. Some countries failed miserably while others were successful in their goals behind demonetization. India has used it on a few occasions earlier in 1946 and 1978; there was also one in more recent years. The first demonetization in India occurred in 1946, which was used to increase the revenue by capturing tax avoiders. This occurred by removing the 5000 and 10,000 rupee notes from circulation. Though it targeted a small portion of the population, it was still impactful. The second demonetization by the government of India (GOI) occurred in 1978. This was conducted to prohibit black money, which refers to money used for illegal activities ranging from tax evasion to financing terrorism that was not accounted for on their taxes. The latest demonetization initiative by the Prime Minister Narendra Modi and the GOI in 2016 was put into place to rid the economy of fake currency, find tax evaders who had wealth in the form of high-value currency notes, and move a large fraction of population into a cashless economy.

The demonetization initiative from 2016 involved banning the 500 rupee and 1000 rupee notes. These notes constituted about 86 percent of the total currency notes in circulation. Because they were no longer going to be recognized as legal currency, the Indian people had fifty days to deposit these notes in the bank or exchange them. This change immediately triggered huge lines of customers in banks and ATMs. One of the issues they ran into was the unpreparedness of the Reserve Bank of India (RBI) to replace the recalled currency notes with new 500 rupee notes and/or the 2000 rupee notes. This caused an insufficient cash flow for the population and businesses for their daily transactions. As a result, different sectors in India were affected: such as, micro, small and medium enterprises (MSME), agriculture, banking, rural and urban area business.

Why was demonetization done (as per the reasons given by the government in the present case )

  • To tackle the menace of black money/parallel economy/shadow economy
  • The cash circulation in India is directly connected to corruption hence we want to reduce the cash transactions and also control corruption and thereby move towards cashless transactions.
  • To counter the menace of counterfeit currency
  • To prevent the cash being used for terrorist activities/terror funding

Advantages of Demonetization

  • The menace of black money can be controlled to some extent
  • Terror financing, using black money for illegal activities, etc will all take a hit
  • The counterfeit currencies which have an impact on the real economy will be rooted out
  • The mobilization of deposits in the banks will increase, which may lead to increased credit flow and lowering of lending rates
  • The black money adds to the inconspicuous demand and hence the inflation to some extent will be under control
  • The government is also aiming to raise its revenue collection (eg- by taxing exorbitant IT rates over certain deposits, the tax collection in other forms will also increase, etc)
  • Real estate is one of the major sources of black money generation. With this move, it is expected that the property market rates may bottom out or moderate
  • It’s a major step by the government towards forming a cashless economy
  • The honest workers will be rewarded under such a scenario
  • The elections are usually associated with black money generation and circulation, with this scheme the funding of elections through nefarious ways will be hit
  • It is expected that with this move the Fiscal Deficit of the government may come down

Disadvantages of Demonetization

  • For one all the black money is not stored in the form of cash only and secondly, the measure takes care of the result but not the cause-black money is generated mainly because of corruption and tax evasion. This measure controls the usage of black money but cannot control the causes
  • Sudden and huge demand for the new currencies
  • Panic amongst the common man (already we have seen the case wherein people have looted fair price shop in MP, Cash Carrying companies seeking higher insurance, etc). already the panic has led to people hoarding currencies which have further reduced the liquidity in the market
  • The small trade/shopkeepers are facing difficulties
  • Black marketing of the new notes/currencies is on the rise
  • The establishments such as banks, hospitals, etc are under a lot of stress
  • Another area that is a cause of worry is the likely drop in the rural demand as the cash usage will become restricted. Apart from this, the experts are also expecting an impact on the SME sector, agricultural production (the economy was expected to perform well as there was an expectation of a good rabi crop after two bad monsoons but a prominent economist, Pronab Sen has said that demonetization is akin to third bad monsoon year as it will have an impact on agricultural production, but the more dangerous situation is this having a spillover effect on to fertilizer, tractor sectors)

Challenges

The coverage of the banking sector-

  • Only 27% of the villages have a bank within 5 Kms (as per Economic Survey 2015-16)
  • Despite recording breaking implementation of JDY, the banking penetration is low-on an average 46% in all the states (as per Economic Survey 2015-16)
  • Another challenge in implementing and eradicating black money would be the presence of the informal economy. It accounts for 45% of GDP and 80% of employment hence this move may have a greater impact on the informal economy
  • Logistics and cost challenges of replacing all the Rs 500 and Rs 1000 notes – as per the RBI documents this measure would cost at least Rs 12000 crore as it has to replace over 2300 crore pieces of these currencies
  • The decision to issue Rs 2000 denomination currency and withdrawal of Rs 500 and Rs 1000 currency will lead to huge challenge as most of the day to day transactions in India are centered around Rs 500 note (more than 47% of the value of notes in circulation is in Rs 500 note form)
  • The availability of Rs 500 and Rs 1000 notes will be the biggest challenge as both of them covered over 85% in terms of the value of total currencies issued
  • The process has led to huge rush and long queues of the people in front of ATMs and as per the statement of the finance minister the ATM recalibration would take around 2 to 3 weeks
  • As per data furnished by the Finance Ministry, Rs 17,50,000 crore worth of currency notes were in circulation in October-end, out of which over 85% percent or Rs 14,50,000 crore is in the now-defunct Rs 500 and Rs 1,000 notes. So far for the first four days, the government has been able to pump in Rs 50000 cr (on an average 12500 Cr). Going by these numbers it would take around 4 months to replace these notes as against the 50 days promised by the PM

Demonetization is measured with both benefits and drawbacks in several sectors in the short run. In addition to this, some of the previous research says in the long run demonetization will have a positive impact on digital payment and monitoring the black currency.

The demonetization forced people to use electronic payment options to buy goods and services. However, the results also indicated that online electronic transactions RTGS, IMPS, and NEFT systems fell both in value and volume in November 2016 as compared with October 2016.

For the common man of India, it seems to be detrimental to their way of life as it decreases their wages. It seems to hurt the agricultural sector as well. For the people in urban areas, the cashless economy should be helpful in making business and personal transactions faster and easier; however, the Indian government is finding out the rapid push to a cashless economy is not as feasible as it once believed. In the long run though, this push for cashless economy will also help build the informal firms into formal firms, which would make those businesses more efficient and less likely to evade paying taxes.

Following are the main impacts.

  1. Demonetization is not a big disaster like global banking sector crisis of 2007; but at the same time, it will act as a liquidity shock that disturbs economic activities.
  2. Liquidity crunch (short term effect): liquidity shock means people are not able to get sufficient volume of popular denomination especially Rs 500.  This currency unit is the favourable denomination in daily life. It constituted to nearly 49% of the previous currency supply in terms of value. Higher the time required to resupply Rs 500 notes, higher will be the duration of the liquidity crunch. Current reports indicate that all security printing press can print only 2000 million units of RS 500 notes by the end of this year. Nearly 16000 mn Rs 500 notes were in circulation as on end March 2016. Some portions of this were filled by the new Rs 2000 notes. Towards end of March approximately 10000 mn units will be printed and replaced. All these indicate that currency crunch will be in our economy for the next four months.
  3. Welfare loss for the currency using population: Most active segments of the population who constitute the ‘base of the pyramid’ uses currency to meet their transactions. The daily wage earners, other labourers, small traders etc. who reside out of the formal economy uses cash frequently. These sections will lose income in the absence of liquid cash. Cash stringency will compel firms to reduce labour cost and thus reduces income to the poor working class.  There will be a trickle up effect of the liquidity chaos to the higher income people with time.
  4. Consumption will be hit: When liquidity shortage strikes, it is consumption that is going to be adversely affected first.

Consumption ↓→ Production ↓→ Employment ↓→ Growth ↓→ Tax revenue ↓

       5. Loss of Growth momentum– India risks its position of being the fastest growing largest economy: reduced consumption, income,      investment etc. may reduce India’s GDP growth as the liquidity impact itself may last three -four months.

     6. Impact on bank deposits and interest rate: Deposit in the short term may rise, but in the long term, its effect will come down. The savings with the banks are actually liquid cash people stored. It is difficult to assume that such ready cash once stored in their hands will be put into savings for a long term. They saved this money into banks just to convert the old notes into new notes. These are not voluntary savings aimed to get interest. It will be converted into active liquidity by the savers when full-fledged new currency supply take place. This means that new savings with banks is only transitory or short-term deposit. It may be encashed by the savers at the appropriate time. It is not necessary that demonetization will produce big savings in the banking system in the medium term. Most of the savings are obtained by biggie public sector banks like the SBI. They may reduce interest rate in the short/medium term. But they can’t follow it in the long term. 

7. Impact on black money: Only a small portion of black money is actually stored in the form of cash. Usually, black income is kept in the form of physical assets like gold, land, buildings etc. Hence the amount of black money countered by demonetization depend upon the amount of black money held in the form of cash and it will be smaller than expected. But more than anything else, demonetization has a big propaganda effect. People are now much convinced about the need to fight black income.  such a nationwide awareness and urge will encourage government to come out with even strong measures.

8. Impact on counterfeit currency: the real impact will be on counterfeit/fake currency as its circulation will be checked after this exercise.

 Demonetization as a cleaning exercise may produce several good things in the economy. At the same time, it creates unavoidable income and welfare losses to the poor sections of the society who gets income based on their daily work and those who doesn’t have the digital transaction culture. Overall economic activities will be dampened in the short term. But the unmeasurable benefits of having more transparency and reduced volume of black money activities can be pointed as long term benefits. 

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