The term demonetisation has become a household name since the government pulled the old Rs 500 and Rs 1,000 notes out of circulation. While as per dictionary demonetisation means “ending something (e.g. gold or silver) that is no longer the legal tender of a country”, one needs to see if there is anything more to the word.
What is demonetisation?
When a currency note of a particular denomination ceases to be a legal tender it is termed as demonetisation. But since our government is replacing the old Rs 500 notes with newer ones and doing away with the Rs 1,000 notes, it would be more appropriate to call the move as `scrapping’ or `phasing out’ of certain currency notes.
What has the government done?
Prime Minster Narendra Modi’s decision to scrap high value notes of Rs 500 and Rs 1,000 has created a shortage of cash in the system, leading to a lot of discomfort for the general public and businesses. Also, since there is a shortage of newly printed Rs 500 and Rs 2,000 notes, the situation has worsened. The move has also led to a shortage of lower denomination notes such as Rs 100 and Rs 50 that are still legal tender, as people have taken to conserving whatever cash they have in hand.
How will it impact the economy?
Since our economy is heavily dependent on cash, as only less than half the population uses banking system for monetary transactions, demonetisation has hit trade and consumption hard. With people scrambling for cash to pay for goods and services, the move is likely to take a big toll on the country’s growth and output during the current fiscal. Consumption makes up for around 56% of India’s GDP, hence, a drop in spending will pull down growth. The current step could also lead to behavioural changes in households’ savings and their consumption pattern, says economists.
De-mon: A multidimensional success
Contrary to the widespread view, de-mon has been a success in bringing into tax account the unmonitored roaming cash amounting to some Rs 3.35 lakh crore — a large part of which is under a tax probe. De-mon has raised the individual tax base by 20 per cent, advance tax collections for 2017-18 by 42 per cent and self-assessment tax (paid now for last year) by 34 per cent. Both in bringing substantial black money of the past into account and in ensuring better tax compliance, de-mon has been a success. An incredible achievement of de-mon is the reduction in the total cash stock and the cash stock with the public. In absolute terms, cash stock has fallen from Rs 17.1 lakh crore to Rs 15.1 lakh crore — a reduction of Rs 2 lakh crore. Without de-mon, it would have topped Rs 22 lakh crore, that is, increased by Rs 4.9 lakh crore. Likewise, cash with the public fell by Rs 2.1 lakh crore. Had not de-mon intervened, cash with the public would have risen by Rs 6.6 lakh crore. Because of de-mon, as the cash with the public came down dramatically, the people’s deposits in the banks went up equally dramatically — from Rs 97 lakh crore to Rs 114.2 lakh crore.
The reduction of cash with the public and the rise in deposits with the banks will produce a dramatically opposite macro-economic impact. Cash with the public fuels and funds the black economy. Deposits in banks will fund the formal and organized sector. Moreover, by the fractional reserve model, money moving in and out of the banks multiplies as advances, by some six times. The flow of de-mon cash into banks — including black money — has already led to a cut in interest rates and a huge rise in lendable money, relieving banks that were stressed by illiquidity. With street cash in the banks, household financial savings rose steeply from an average of 10.5 per cent of the Gross National Disposable Income [GNDI] in the five years to 2016 to 11.8 per cent in 2017. Withdrawal of cash from fuelling asset prices will certainly hit GDP growth, but this near-term hit is necessary to shift the gear of the economy from jobless growth through asset price rise to growth with jobs. The impact of drawing money from the public and quarantining it in banks has crashed land prices in different parts of the country. The impact of this is clearly visible in the realty and housing sector, where asset price rise in land had stagnated the housing sector since at least 2012.
Prime Minister during Demonetization
Prime Minister Modi has also signaled that the demonetization was a first step against corruption and tax evasion, and property records will be digitalized as well. These digital records are used to identify individuals who have been registering assets under other peoples’ names in order to avoid taxes. The property digitalization operation will put additional stress on the real estate sector.
Before the revision, the magnitude of informal sector output was peroxide by combining information on value added per worker from national surveys with employment data per industry.
What does lower growth means?
Growth in cash-intensive sectors such as real estate, construction and FMCG is likely to take a hit in the short term as consumers are deferring purchases. However, there is a positive side to the story: over the medium term, there would be benefits through higher government spending and greater financial inclusion. Also, the movement of household saving from physical to financial will help boost growth, according to Yes Bank report. The near term fall in growth on account of spending slowdown, could push inflation down. Also, an increase in fiscal headroom will allow the government to maintain fiscal discipline, which in turn will support inflation target in the medium term.