Why Demonetisation Is Not Good News For The Indian Economy

Posted by Manisha Rao
December 1, 2016

Is demonetisation, as many people have been calling a ‘surgical strike’ or just another political gimmick? The demonetisation move has received both, appreciation and criticism from across the country. As an economic policy, it is rightly intended to check counterfeit currency that’s in circulation in the economy but wanting to remove all the black money from the market through demonetisation is quite debatable.

In 1978, under the leadership of Morarji Desai, notes of denomination ₹1000, 5000 and 10,000 were demonetised and taken out of the economy to curb the menace of black money. But it hardly did anything to stop the problem. Rather, there has been an exponential increase in the volume of black money and there are more fake notes in circulation.

Narendra Modi’s decision to demonetise has been called ‘bold’ and ‘historic’, but is it? India, as a country, is diverse in its economic structure and introducing such a massive change to the economic system can cripple the country. This move will have far-reaching repercussions on the economy and will affect almost everybody, from the daily wage earners to big conglomerates, from chai wallahs to steep companies, from the dollar to the rupee.

Upon the announcement that ₹500 and ₹1000 notes will cease to be legal tenders, a liquidity shock engulfed the whole country leaving people panicked and furious. Cash accounts for only four percent of the total black money in the country. Launderers or tax evaders usually do not keep black money in cash. They convert it into property or gold bullion. A major portion of the black money is stashed away in the form of assets. The ‘Modi-leher’ might have become a nightmare for the hoarders of black money, but the corrupt ‘babus’ are still in the system. Corruption will continue but in slightly different arrangements.

Demonetisation has drastically brought down consumption in the country. People have curtailed their expenditure due to low cash supply. This eventually will lead to fall in the prices of some commodities, thereby, reducing the rate of inflation initially. The markets expect a decline in the GDP by 0.5 percent in the next financial year followed by recovery in 2018. Demonetisation will also have an adverse impact on micro, medium and small enterprises as they are labour intensive. Owners and workers will equally face the heat of demonetisation.

People in the hopes of getting their notes exchanged have deposited cash into the banks which has led to surplus cash reserves in the banking sector. Banks have lent over ₹1.5 lakh crore to the RBI using reverse repo option. The balance sheets of banks are in no position to handle this abundance even if they decrease the deposit rates. This surplus cannot be used for lending or investments as they are short-term deposits and involuntary in nature. The slowdown in debt service flow is likely to happen as the rural sector is highly cash-based. Banks will have to keep down their loan disbursal, recovery or financial intermediation in queue till the cash situation normalises.

Cash crunch has led to a leakage in India’s large trading system and on the other hand, financial markets and the rupee are tumbling down owing to the unprecedented liquidity shortage. The stock markets have lost around ₹1.5 lakh crore since the note ban. Fresh investments and market expenditure will remain choked till the liquidity shock ceases.

Any macroeconomic policy might be implausible at this time due to its dynamic nature. Demonetisation is good for Narendra Modi’s political career but comes at the cost of economic growth. The government is making tall claims about long-term benefits of demonetisation. But even after two weeks of the announcement, the situation hasn’t changed much. Giving voice to the united opposition’s stance against demonetisation, the former Prime Minister Manmohan Singh in the recent parliament session criticised the government and recalled J.M. Keynes’ words, “In the long run, we all are dead.”

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Image source: Hindustan Times/Getty Images

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