The Great Indian Demonetization

On the 8th of November, Prime Minister Naredra Modi in his address to the nation announced Rs. 500 and Rs. 1000 would no longer be recognized as legal tender. The move to demonetize high denomination currency has been welcomed by the public. One does wonder what the implications of such a move would be. Over the next few posts, I shall try and cover as much ground as possible.

The impact of the move can be assessed through a few macroeconomic indicators:

Inflation

There could be a temporary decrease in inflationary pressure in the economy as household demand reduces. However, in the event people start increasing the purchases essentials due to the scarcity of cash, there could be an upward pressure in prices.

Exchange rate

Rupee will depreciate as there is an increase in rupee currency in circulation as well as the demand for dollar. FPIs have continued their selling spree. While there are global factors at play, the increased pressure in equity markets following the demonetization move has added to the outflow. The Rupee has moved from Rs. 66.236 on the 9th of November to Rs. 67.992 on the 17th.

Growth

Given the restricted access to cash and the uncertainty in the general atmosphere, household demand will experience a sharp decline. This will result in slower growth in the current quarter. This sentiment could spill over to the next few quarters depending on the access to cash and the government’s ability to make things normal.

Current Account Deficit

The current account deficit could reduce due to the impact of a change in exchange rates. In the first quarter of the current financial year, the current account deficit stood at 0.1% GDP as compared to 1.2% in the same quarter last year. There could be an increase in exports and a decrease in imports given the rupee depreciation. However, this is also based on the timely flow of credit to businesses. As people look for alternate avenues to store currency in, gold could see an increase in demand. However, given the government’s declaration of monitoring jewelers and jewelers shutting shop in many parts of the country as a response, this demand could translate into a limited increase in the volume of gold. The day following the demonetization announcement, the price of gold shot up for a day. Since then, the price has been a steady decline. However, there are reports of 10 grams of gold being traded at prices as high as Rs. 52,000.

Fiscal Deficit

Government’s tax revenues could increase as a large part of the cash (close to 86%) circulating in the economy is forced back into the system and the tax net widens. The increase in tax revenues could be spread out over a reasonable time period as there could be litigation and other legal hurdles surrounding the tax bill that the government may give those who report a stark increase in unsupported income. With better monitoring of transactions and tracking fund flows, the revenues maybe higher in the foreseeable future. This could help reduce the government’s fiscal deficit.

Monetary Policy and Policy Transmission

While there will be more effective passage of monetary policy transmission by banks in the short run, it may not translate into the desired effect. Banks have dropped their deposit rates. Given that the cash will flow in without much cost to the banks, there could be another drop in deposit rates. However, there could be some resistance/ time lag in lending rates being reduced.

In the medium and long run, there could be more effective policy transmission as a large number of households and individuals have now come into the fold of the mainstream banking.

 

Over all wealth

There could be a decrease in wealth if people with large amounts of cash cannot find ways to convert their old notes. As the penalty can go up to 200% of the tax amount, people may find it cheaper to get rid of the cash that cannot be converted. Wealth, legal or otherwise, that they possess has been accumulated over a period of time. The erosion of such wealth will have a strong impact on the economy. There will also be a redistribution of wealth on a large scale as people try different avenues to convert their cash.

 

 

Sectoral Impact

As both buyers and sellers move to alternative payment methods, Fintech companies will gain stand to gain. Shops and restaurants with/without card machines have now moved to PAYTM (an e-wallet) to service delivery orders. There has been a shift in shopping from street hawkers and only cash set ups to those with cash less payment avenues. Those who don’t have alternative payment mechanisms may experience a sharp decline in business volume.  Non-essential consumption appear to have been postponed. This could impact the consumer goods sector. Cash deliveries will see a decline. This will temporarily reduce delivery costs but this will be accompanies with a fall in top line as well. Taxi aggregators such as Ola and Uber will see an increase in usage as people shift from cash only public transport to cashless taxis.

While luxury goods as a whole will experience a decline, certain segments could experience a temporary spike in sales. There have been reports of large volume sales of Rolex Watches, etc as people look for avenues to convert cash. Real estate, agriculture, commodities will also be negatively affected.

Due to the decrease in household demand, businesses may witness a slowdown. Businesses who depend heavily on cash transactions have faced a disruption in their day to day activity. Some businesses who continue to experience strong demand may face problems due to a crunch in liquidity and cash flows as banks are caught up with the swapping of currency and accepting deposits.

 

While the move is well intended and must be lauded, good intention cannot be used as an excuse for inefficiency. While people will temporarily support the move, there could come a point where the masses run out of patience and negative sentiment takes over.

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