December 2, 2016

News in Charts: India’s Demonetization – Immediate Pain for Uncertain Gain

by Fathom Consulting

Prime Minister Modi’s unexpected decision to demonetize 86% of India’s outstanding currency in a bid to combat corruption and tax evasion is without precedent. An ensuing liquidity crunch means that economic growth is almost certain to slow in the short term as spending is displaced, perhaps knocking two percentage points off GDP growth. The decision is an effective tax on the informal economy. But without accompanying reform, the medium term impact on corruption and tax evasion may not be as great as hoped.

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Modi lives up to reputation for reform

India’s leader, Narendra Modi, continues to live up to his reputation as a zealous reformer. Following changes to Foreign Direct Investment laws, and the introduction of a long-awaited Goods & Services Tax, his latest economic restructuring is the boldest yet. In a televised address a little over three weeks ago, he announced that the country’s Rs500 and Rs1000 notes would cease to be legal tender overnight, and would be replaced by new Rs500 and Rs2000 notes. The decision to abolish almost 90% of outstanding currency in a nation noted for its fondness of cash was nothing less than audacious, and will come at the cost of short term growth. But will it pay off?

Ostensibly, the demonetization is aimed at combating the ‘black’ economy. It is true, many who have accepted bribes or evaded taxes will feel more than a pinch as they are unable to legally replace their old notes for new ones. The real estate sector, a traditional home for laundered cash, should suffer too. However, without accompanying reform, the medium term impact on corruption and tax evasion remains highly uncertain at best.

Blow to growth unavoidable

India’s economy is particularly reliant on cash, meaning the economic impact of demonetization will be greater than if implemented elsewhere. Notes and coin amount to 12% of GDP, which is high relative to both advanced economies and emerging markets. And the notes in question make up 86% of all cash in circulation, meaning almost the entire stock of money needs to be replaced.


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Around two-thirds of consumer spending relies on cash and will be affected. There will be a negative shock while the process of exchanging old notes for new ones takes place, as shoppers are not able to complete all of their desired purchases. Smaller firms who rely on cash will also face liquidity shortfalls, weighing on business expenditure and stock replenishment.


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The inefficient implementation of the demonetization has exacerbated its negative effect. The government did not have a sufficient stock of new notes to replenish the old ones. Even where cash was available, low weekly withdrawal limits for both businesses (Rs50,000) and individuals (Rs25,000) ensured a liquidity crunch, with ATMs only able to dispense Rs2500 per day. Logistical difficulties in printing and delivering notes across a country the size of India suggest that the negative effect on economic growth should last until the first quarter of 2017 at least.

Personal consumption makes up 55% of economic output, of which 67% is in cash. In other words, at least 37% of GDP is directly related to cash consumption. A crude calculation suggests that the reduction in M0 from India’s demonetization could knock off 1.8 percentage points from GDP growth. Once the additional impact from the negative shock to the informal economy is included, that number would be expected to rise above two. If our calculation is right, and the peak impact occurs before year-end, it would be consistent with broad stagnation in economic activity this quarter.

That expected economic slowdown opens the door for further Reserve Bank of India (RBI) easing. Market interest rates have dropped sharply since the demonetization, and are consistent with a 25 basis points reduction in the repo rate at the RBI’s December meeting. That will do little to offset the current deceleration in economic growth but could support a stronger recovery next year as the economy adjusts to a new equilibrium.


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Further reform required to ensure lasting effect

The informal sector, which is believed to be equivalent to around 25% of GDP, will suffer disproportionately from demonetization. Citizens with illicit cash piles, either from illegal activities or undeclared income, face an effective wealth tax as they will be unable to legally replace their holdings. Deposits of over Rs250,000 will be subject to a 30% tax and potential additional penalties, making this an unattractive option. Attempts at exchanging figures above that underground will no doubt be accompanied by haircuts. That hit to savings will ensure that some informal businesses fail, with negative knock-on consequences for the customers and workers that rely on them.

Real estate is another sector that will be disproportionately affected. Many transactions, particularly at the lower end of the market, rely heavily on a cash component. And real estate is often used as a conduit to launder illicit gains. Indeed, previous studies have found that India’s ‘black’ money is mostly stored in physical assets such as real estate and gold, raising broader questions about the efficacy of demonetization. Property prices are likely to ease, reflecting both the cash shortfall and negative impact on the informal economy.

Without accompanying reforms, demonetization’s medium term impact on corruption and tax evasion may not be as great as hoped. Once the one-off effect on the informal sector has passed, there is little reason to expect illicit activity not to re-emerge under the new currency. Indeed, the introduction of a more valuable Rs2000 note should actually facilitate bribery. An unintended consequence of this experience may be to incentivize those engaged in the informal sector to adopt more efficient and timely money laundering systems.

Test case for proponents of cashless economies?

The negative impact of demonetization on short term GDP growth appears clear cut. Any potential economic benefit further out is more uncertain. One thing that seems assured is that the experiment will be closely watched. Interest rates are near or below zero across many of the advanced economies. And the enduring use of cash has been pointed to as an unhelpful impediment to policy rates falling deep into negative territory. If India’s experience turns out better than expected, it is likely to be keenly noted by outside observers.

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