The move bythe legislature to demonetize Rs.500 and Rs.
1000 notes by supplanting them withnew Rs.500 and Rs.2000 notes has taken the country with surprise. The move bythe government is to tackle the threat of black money, corruption, terrorfunding and counterfeit currency. From a market perspective, this is anexceptionally welcome move by the government and which has taken the blackmoney hoarders with surprise. The total value of old Rs.
500 and Rs.1000 notesin the circulation is to the tune of Rs.14.2 trillion, which is around 85% ofthe aggregate value of currency in circulation. This implies the total cash hasto now pass through the formal banking channels to get legitimacy.
The WorldBank in July, 2010 evaluated the measure of the shadow economy for India at20.7% of the Gross Domestic Product (GDP) in 1999 and climbing to 23.2% in 2007.Expecting that this figure has not rose from that point onwards and that thecash component of the shadow economy is also proportional (it could be higher),the surveyed unaccounted value of the currency could be to the tune of Rs.
3.3trillion. Presently, post the announcement of demonetization by the government,this cash would need to be either represented by paying the relevant taxes andpenalties or would get extinguished. Thepositive macro benefits of this move by the government This move bythe government is likely going to have long haul benefits for the economy.
The removingof the significant amount of black money would decrease from the liabilities ofthe government and would add to its finances. This can have very strongramifications as the government would get money to spend without borrowing fromthe market. This would infer that while financing costs will be low, the governmentspending on large infrastructure projects would kick start capex cycle and pusheconomic growth higher in the medium term.
The move is alsoinclined to have a propensity changing effect in the Indian population andthere could be increased belief of keeping cash in the banks rather thanreserved at home and utilize formal banking channels for their spending needs.With a large proportion of the cash moving through the banking channels, thebanking sector is likely to be flushed with funds in the near term and thiswould help them decrease cost of funds for such period. Also with more moneybeing kept in the banking channel, some of these low cost deposits may besticky and improve the medium to long term Current Account and Savings Account(CASA) ratio of the banks. Anotherimpact of the demonetization would be reduction in cash transactions in realestate sector. This is probably going to reduce the land costs and make itaffordable to some extent. This might be more prominent in the rural areas,where a number of non-farming entities buy farmland, not for cultivating butrather for cash hoarding. The demonetization and consequent reduction in shadoweconomy would bring the demand for such farm lands down.
This move islikely to lead to better tax compliance, raise the Tax to GDP ratio and increasedtax collection. This could lead to lower borrowing and better fiscalmanagement. Also with lower cash transactions in the near term, inflation maysee downwards trend in the near term. Also with higher tax to GDP ratio, thegovernment may also get enough headroom to reduce the income tax rates, whichcan lead to higher disposable income with people and can improve consumptiondemand in the medium to long term.Howeverthere could be near term challengesIn the near term,the reduced capacity of the unorganized sector to deal in real money willimpact the demand Consumption items which has a huge element of cash dealinginvolved, may see lower demand. Real estate and allied sectors may see nearterm to medium term negative impact. This may also lead to corporate earningsgetting impacted in Q3FY17, as a large part of the old currency gets extinguishedand takes time for new money to come into circulation.
Impact on GDP and economyThe Indian Economy which was labeled as the”fastest growing major economy” in the world and the “only bright spot” amongEmerging Markets appears to have slowed down even before the recent “shocktherapy” of “demonetization”. The recently released growth figures from theCentral Statistical Office, shows a decline in the Indian economy even duringthe quarter before demonetization happened.India’s GDP which grew at 7.6% in FY 2015-16 is likely to come down by 0.5% to 1.5% as perreports of various agencies. This is due to less availability of cash in cash-intensive sectors like manufacturing andreal estate. Even the automobile industry which was growing at a fast paceearlier has seen a drop in the October-December quarter of 2016.
Purchasingpower of consumers has been negatively affected due to cash not being readilyavailable. Indian economy is largely cash driven with more than 90% transactions taking place incash and digital transactions accounting for just the remaining 10percent.Banks have also been concentrating only on the deposit andwithdrawals with the result that their core function of issuing loans has been adversely affected. Alsocurrent account customers, who are largely business owners, need huge amountsof cash at short notice and they have not been able to avail cash and creditowing to restrictions on withdrawals and inability of banks to focus on thetask of issuing loans. Also since consumer demand has dropped and consequentlyindustrial production has declined, employmentgeneration has been adversely impacted by the currencydemonetization drive. Since the manufacturing sector which accounts for thehighest employment of skilled and semi-skilled laborers, is witnessing slowdownin production; not only less jobs are being created but lay-offs are alsotaking place at a very high rate.
Whilethis move by the Indian Government will definitely remove the fake currency,its impact on the black economy and corruption is highly debated. While inisolation demonetization might not be effective in shrinking the black economyin the long run, it will definitely bring in most of the money back into thesystem from where tracing and tracking can be done with much ease. Furthermoves by the government like not allowing high amount of cash expenses as a taxdeductible expense is expected to increase the tax revenue of the government.