Impact of Demonetization on the Indian Economy

By Pradeep Kodali and Divya Kalagara

Abstract

Demonetization is a major decision taken by the government of India. The context in which the decision
was taken shows that it is a well-intentioned and a timely decision. There may be other options at the
government’s disposal to push the country’s GDP higher but demonetization is certainly one of the best
ideas. There are many ways in which it could benefit the country and address a number of problems that
have been holding the country back. It is shame that the implementation was shoddy and failed on
many fronts causing discomfort to a large majority of the population that is not the target of this
operation. The main failure of implementation is in the planning stage, ATM calibration and INR 500 new
note shortage, problems that could have been avoided by being more thorough. It is due to the sheer
will of the population who completely bought into the potential of the idea that the country came out of
this largely unscathed.

The poor implementation might have also helped the government in keeping up with the operation and
plugging loopholes on time. Demonetization also has its demerits but the positives largely outweigh the
negatives. It is not a complete solution in itself but one of the many steps required to bring down the
parallel economy as well as reduce corruption. The government seems to think that way also which
brings hope that demonetization will go down in the history books as the moment that brought India
onto the path of high growth and efficiency. But, there is definitely a high risk that this could remain one
of the most expensive and futile experiments conducted by any government in the world. Only time will
tell.

The context of Demonetization

Since coming into power in 2014, the current government has taken up a number of initiatives, like
“Make in India” to increase the pace of the Indian economic growth, which is captured by the real Gross
Domestic Product or GDP number. GDP is a measure of the value of the economic activity of a country
and the higher the real GDP the better it is for the country as it creates more employment and results in
better paying jobs for the population of the country. The increase in per capita income would then
translate into better purchasing power allowing the citizens to lead better lives thereby moving the
country towards the living standards of the developed world. The other important number is Inflation
(CPI or WPI) which measures the increase in prices of goods and services, which the RBI wants to
maintain between 2% and 4%. The GDP growth of India according to the economic survey of 2014 is
6.1% and in 2016 that number is 7.3%. The positive change in GDP number is largely attributed to a
change in the method to arrive at it and the comparable number in 2014 is around 7.1%. So, the GDP
number has not changed much, but actually decent as the world economy was registering only around
3% GDP growth rate. While China remains the fastest growing country in absolute terms, India has
become the fastest growing economy in percentage terms since 2015 up until November 8th 2016.
Consumer Price Inflation, CPI, was around 4.2% in September 2016 which was well within the comfort
zone of RBI. So to sum it up, India was growing at a reasonable pace compared to the rest of the world
and inflation is well within control. With a good monsoon in 2016 after two years of below average
rains, the GDP expected to reach closer to 8% in FY17. A regular coalition government would have been
happy with these numbers but more success is expected of this government which came to power on a
developmental agenda and was elected with a full majority for the first time after 30 years.

The government had taken up a number of initiatives to push growth higher. It has tried to revive the
investment cycle which would bring in many big investments and create a lot of employment. RBI has
helped this along by cutting the repo rate by 1.75% in the last two years. But, with the former RBI
governor’s operation to clean up the bank balance sheets of NPAs, the banks are depleted of funds and
are sticky about reducing the rates. The goods and services tax is set to roll out from July 2017 after
going through a number of political obstacles. This will create a uniform tax code for the entire country
making it easier for businesses to expand and grow but it could take a few years before the benefits of
this act can be seen. Land rehabilitation bill was passed in 2015 but only after it was diluted to allow for
social impact assessment, which could result in huge delays in proper acquisition of land for projects and
for infrastructure. Efforts were also made to reduce gold imports by incentivizing Indians to deposit idle
gold into banks so that they can be used as capital. A black money declaration window was provided for
tax evaders to declare their unaccounted income and pay tax on it along with a nominal fine of around
15%. These efforts failed to have the desired results as people could not change their habits. But, they
are destined to fail as the incentive to change was not enough compared to the magnitude of change
expected. There were many other initiatives – some big, some small – but the bottom line is GDP has
not budged much and the government is nearing the half way mark of its tenure before it seeks re-
election. Moreover, it is only months away from important state elections which are important for
gaining an upper hand in Rajya Sabha and for building momentum for 2019 elections.

Demonetization of Indian Currency

On November 8th PM Modi surprised everyone with an immediate ban on INR 500 &1000 notes which
comprises around 86% or 15.6 lakh crores of all the money in the system. The message given to the
nation by the PM was that it was a “surgical strike” on black money and it would be a major force in the
fight against tax evaders. There are two kinds of black money - first kind and probably the most common
is money made “black” by hiding it from tax authorities to evade paying tax. The second kind is money
from illegal sources of income – mostly bribery and other forms of corruption. There is a theory that the
second kind kindles and encourages the first kind of black money. That means businesses hide money to
generate black income which they can then use as a bribe to protect their business – like a type of
indirect tax only this tax does not reach the government and therefore cannot be used for the welfare of
the citizens. The main idea behind demonetization is if the usage of cash is reduced, then it would be
harder to divert money into the black economy and to hold money in cash. So, businesses cannot make
money “black” and corrupt officials cannot shore up “black” money. This will result in more tax revenues
and funds at government’s disposal to give a fillip to the economy, contributing to a virtuous GDP cycle.

For an idea that made quite a bit of sense, it is sad to see what followed over the next fifty days. The
entire country spent most of its waking time standing in lines to exchange their now demonetized notes
for new INR 2000 notes. What is more disheartening is that it is the poor and the under privileged that
suffered the most while the rich used their influence to get privileged access or simply used cards to
take care of themselves. Farmers also suffered as their perishable produce was now either not picked up
or picked up and paid for in illegal old notes. The daily worker could only work alternate days as he/she
spent the remaining days exchanging their earnings as they too are used as sources to get rid of old
notes, by the wealthy. There were reports of people passing away from heat strokes or dehydration.
Meanwhile, IT raids revealed hordes of new notes amounting in crores of rupees with the wealthy. The
country’s GDP went down by up to a whole percentage point, by some estimates. All this makes one
question if the whole exercise is worth the trouble.

The Positive Impact of Demonetization

The travails of exchanging currency have created a sense of discomfort among the population to hold
lots of currency in future, even though it is unlikely for a repeat act anytime soon. As the current
government’s intentions have become clear it will make holding black money more expensive. The
benefit people get from not paying taxes is actually quite low, when considered fully. When someone
invests black money he/she is showing a lower price of the asset, typically land. When the sale is finally
made, in an era where the government manages to bring the market prices on par with the registered
prices, the capital gains tax on their investment would be a lot higher than required. Gold which is the
other popular avenue to divert black money is a dull investment that offers very low returns. It is better
to earn an interest on fixed deposits by having the money in the bank than to keep it idle in the form of
gold for a period of 4 years. Also, as India imports all of its gold it would really help the government
reduce fiscal deficit if Indians stop buying gold. Demonetization would likely also help in this regard as
there would eventually be less corruption and less tax evasion thereby less money to buy imported gold.

The government expected that around INR 2 to 3 lakh crore would not get back into the banking system
because of demonetization. The latest reports show that only around INR 60,000 crore might not have
made it but RBI is yet to confirm these reports. Nevertheless, with all the data of deposited money at
their disposal the government will be able to collect taxes to meet their target by unearthing black
money. This money can then be used to kick start key government initiatives including infrastructure
projects that would give a huge boost to the GDP.

Indians finally cleaned up their homes and deposited idle money in banks. SBI expects that 40% of this
money, around INR 5-6 lakh crore, will stay in the banks. This will leave more funds in the banking
system which will eventually result in lowering the lending rates. This could help actually revive the
capital credit cycle at a time when bad loans or NPAs have sucked money out of the banking system.
This whole exercise will bring more people under the tax net as the data on deposits can be used to
enforce tax collections better. It is important to remember that out of 1.2 plus billion people only 40-50
million pay any taxes, which is less than 4% of the population. This will improve both direct and indirect
tax collections though the impact on direct taxes is expected to be higher. The data on tax collections in
the months of November and December seems to suggest this to be happening already. But it might
also be people getting rid of old notes to clear tax dues or paying taxes in advance.

One good side effect of demonetization is that with fewer cash in circulation it would make terror
funding that much more difficult. Terror cells are organized by paying their employees in cash as they
would like to stay under the radar. There is also hope that India would move towards a less cash society
and this would bring efficiency to resource deployment thereby creating a positive environment of
growth and risk taking. Lastly, this effort will put a serious dent to traditional political funding thereby
allowing for fair exercise of voting rights by the citizens. Regional political parties are expected to be hit
more than national parties but on the whole there will be less cash to pay for votes.

The Negative Impact of Demonetization

It is not entirely clear if the shock and awe element of cancelling the old notes at the stroke of midnight
is a good move on the part of the government, given how poorly they were prepared to carry on the
exercise. The main issue was the recalibration of the ATMs to dispense new INR 2000 and INR 500 notes
whose sizes have been reduced in order to print more currency at lower costs. The other issue that was
not properly thought through was printing INR 2000 notes instead of INR 500 which made transacting in
currency impossible for lack of change. On the other hand, it is difficult to judge if the move could have
worked any better had it not been so secretive. It is a clear to everybody that the preparation for this
massive undertaking has fallen short and the government and the RBI are to be blamed.

The pain of the note ban spread through the country over the next two months and could have ended
up being a hugely divisive issue that would have created a lot of chaos because of politics. A weak
opposition worked very much in the government’s favor. The understanding of the people of India was
commendable and just shows how much this country is awaiting a government that acted against
“black” money. The Indian imagination was probably attuned by all those movies against corruption that
created hope that there will be plenty of gain eventually. The hard work of the banking staff is
commendable even though a few bad apples helped the black money hoarders convert huge sums of
old notes thereby denying them to the public which added on to the inconvenience. On the other hand,
one could argue that the delay allowed the government to plug most of the loopholes which were being
used to put “black” money into the system, as “white”.

The other major issue is the political vendetta aspect of the move. Given the timing of the move right
before state elections in Punjab, Haryana, UP, Goa and Manipur this move is also intended to throttle
political funding of the opposition comprising of smaller regional parties. It is good to have less money
to purchase votes but one would expect it to be the same for all parties. The government, in this case,
has gained a lot at the expense of the opposition and it could set a bad precedent where similar tactics
could be used to exact political vengeance.

Another major flaw with demonetization is the fact that India is a heavily cash based economy. We are
probably the biggest cash based economy going by the amount of cash in circulation as a percentage of
GDP. We are definitely not a digital economy and trying to move to a less cash economy is not easy.
There is a learning curve and need for a lot of digital infrastructure to make it happen. Demonetization is
like a bitter pill which is forcing people to move to a less cash society quickly. Government launched
financial inclusion activities to bring millions of Indians into the banking system earlier and recently
launched BHIM, Bharat Interface for Money, to provide free digital platform for all the Indians. But there
is still a long way to go to become a less cash society and this road is fraught with risks. I only hope the
government keeps working towards resolving all the issues by providing necessary training and support
especially to people in rural areas who are the most vulnerable to this kind of change. Demonetization
at best is still a work in progress and a lot more effort is required in making it a success.

Lastly, the government’s plan to get a windfall of a few lakh crores has not happened right away but
with the amount of data at its disposal and with the self-declaration schemes it may reach its target. By
some estimates, the whole demonetization exercise might have cost at least INR 25,000 crore and now
it would cost the government even more to file tax notices to recover tax money.

Conclusion

It is easy to criticize but difficult to do things. I appreciate the government’s efforts in trying to bring
positive change that will have long term benefits for the entire country. There have been many issues
with the implementation, which could have been handled a lot better. But, in retrospect poor
implementation might have helped in buying time to deal with the many ways in which the hoarders
tried to exchange currency. I do not support all the intentions of the government as some of those are
selfish and may have set a poor precedent for the detriment of the democratic society. This is still a
work in progress and only time will tell if demonetization is good for the country or if it is just a futile
expense that caused a lot of pain to the population. PM Modi does not see this as an end in itself but as
the beginning of his fight against the scourge of black money and he seems determined to bring down
the parallel economy. The fight against black money, of which demonetization is only a step, along with
GST would bring in a lot of positive changes over the next year.

The immediate steps the government should take up in order to continue on this path of
demonetization are 1) provide a growth friendly budget 2) encourage people to move towards digital or
less cash economy through incentives 3) follow up on the information obtained from the
demonetization to identify tax evaders and make them pay their rightful share of taxes 4) Provide
funding for infrastructure which is an important driver to GDP growth and lastly 5) implement
digitization of land records to restrict the biggest avenue for “black” money. As the world is poised for a
good year of growth, these changes will hopefully push India towards becoming the fastest growing
economy in absolute terms also.
References

 http://indianexpress.com/article/opinion/columns/modi-government-three-years-best-for-
india-economy-since-1996-2822478/
 http://www.tradingeconomics.com/india/inflation-cpi
 http://in.reuters.com/article/india-rates-finmin-idIND8N0TU01V20150115