On November 8, 2016, The Government of India took a drastic step by banning the usage of the 1,000 rupee and 500 rupee currency notes with immediate effect and without any prior warning. This demonetisation measure was aimed at a reduction of what is called “black money.” Black money is a term used in India to refer to financial assets and/or money held by persons which has not been disclosed to tax authorities and is thus held illegally. In India, a common belief is that such black money is held by the people in the form of higher denomination currency (500, 1,000 rupee notes). Prime Minister Modi of India, in order to expose such forms of tax evasion and greatly reduce black money sought to implement this “Demonetisation” by replacing the 500 rupee and 1,000 rupee notes with new 500 rupee and 2,000 rupee notes.
This article series will analyze whether Demonetisation fulfilled its stated aim or not and assess the impact of Demonetisation as a whole on the economy by looking at its effects in both the short and long run in order to obtain a clear picture. The first part in this two-part series will look at the short term impact of demonetisation while the second part will focus on the long term effects.
Demonetisation has had an adverse impact on India’s economic growth in the short term. India’s higher denomination currency of 1000 rupee and 500 rupee notes constituted 86.9 per cent of the value of total currency in circulation. A Demonetisation of 86.9% of the total value of the currency in circulation has had a rather obvious impact on the country’s economic growth in the short term. According to a paper published by the Monetary Policy Department of India’s central bank, “about 78 per cent of all consumer payments in India are effected in cash. It was, therefore, obvious that the currency squeeze during the demonetisation period would have had some adverse impact on economic activity [.]” The reasons for this adverse impact are twofold. Firstly, a constriction of this kind to the cash available in the Indian economy led to a decrease in demand for commodities. Secondly, the shortage of cash led to a disruption in production activity, especially in the unorganized sector in which wage payments are made in cash.
Evidence of this adverse impact of demonetisation on the Indian economy is visible in a lot of economic indicators. India’s GDP growth has slumped due to demonetisation in Q4 of FY’17. According to The Economic Times, real GDP growth in Q4 of FY’17 slumped to 6.1 %. The economy’s growth for FY’17 slowed down to 7.1% due to this figure. This is the lowest yearly growth in two years. This was however in line with the official estimate but down from the revised growth of 8% in FY16.”
The Gross Value Added at Basic Price to the economy at 2011-12 prices or “real GVA” in Q4 of FY’17 increased only by 5.2% from the previous quarter, according to data released by the Ministry of Statistics and Programme Implementation. What is even more noteworthy is that the GVA in Q4 of FY’17 for Construction saw a contraction of 3.2% from the previous quarter. The figure on construction is highly indicative of the negative effects of Demonetisation as the construction employs a high proportion of unorganized labour with wage payments made in cash.
The implications of these numbers have been contested by Urjit Patel, the Governor of India’s central bank in an answer to questions raised by The Economic Times. Patel states that “[t]he data also shows that agriculture,. mining and querying – two areas which are highly cash intensive – are not affected by demonetisation. Rural wage growth has remained elevated, especially compared with agriculture labour inflation. Manufacturing as reflected in corporate sales growth in the IIP, electricity and other utilities, trade, hotels, transport and communications have been resilient in the second half of 2016-17.” He also stated that the slowdown of the economy in Q4 of FY’17 was due deceleration in gross fixed capital formation during Q1 to Q3 and then a contraction in Q4.”
While the words of Mr Patel are true, with all due respect to him, there seems to be conclusive evidence that demonetisation has been responsible for the dismal figures. According to livemint.com, “if we leave out public administration, defence and other services as well as agriculture on the grounds that agricultural growth is chiefly due to the rain gods’ generosity, then [the GVA] growth in the rest of the economy at constant prices plummets to a piffling 3.8% for the fourth quarter.” A similar exercise if conducted for FY’16 yields GVA growth at constant prices to be 10.7%. “The full impact of demonetisation may therefore be gauged in the fall of growth in this part of the economy from 10.7% to 3.8%.”
Industrial production has also taken a hit due to demonetisation. In December 2016, the Index of Industrial Production saw a growth of 2.6%, which is a 0.9% drop from 3.5% growth recorded in December 2015, according to the Ministry of Statistics and Programme Implementation(with 2011-12 as base year). The IIP recovered in January to reach 3.8% but with a 0.6% decrease from the previous year. While the IIP as a whole may show signs of having recovered or been unaffected by demonetisation, the same could not be said of the manufacturing sector IIP. In December 2016, the manufacturing IIP slowed down to 0.9%, this is dismal when compared to the 3.4% recorded in December 2015. The manufacturing sector employs a great degree of informal labour and pays wages in cash and this data clearly indicates that demonetisation has led to a contraction in production activity. The table below show the manufacturing IIP growth(in %) with figures from the previous year provided for comparison. There seems to be a clear trend of decline in manufacturing with only January providing an exception.
December 0.9 3.4
January 3.0 4.5
February 1.4 6.7
March 1.2 5.0
The positive impact of demonetisation is to be found in the inflation figures and the rise in digital payments. Inflation cooled to 3.41% in December 2016 on account of demonetisation that led to a reduction in the price of vegetables, according to The Economic Times. “This is the lowest level at least since January 2014. The Consumer Price Index (CPI)-based inflation stood at 3.63 per cent in November 2016, as per the data released by the Ministry of Statistics and Programme Implementation. A year ago, in December 2015, retail inflation was at 5.61 percent. However, this fall in inflation is hardly doing any good for the economy and this is visible when one reads the inflation data along with the growth data. Moreover, The Reserve Bank of India declined to reduce rates in December even after the lowering of inflation to such an extent which prevented lower inflation from benefiting the economy.
The area where Demonetisation seems to have had an uncontestable positive impact is the uptick in digital payments. The Economic Times reports that “[c]ard transactions at point of sale (PoS) terminals at merchant locations have surged, reflecting a positive for the economy as more people start using their debit cards for payments rather than for withdrawing cash at ATMs. Debit card transactions [have risen] to more than 1 billion in January from 817 million last year. While ATM transactions have remained constant at around 700 million, the incremental growth has been driven mostly by card swipes at PoS terminals.” PPIs (Prepaid Payment Instruments) reported an average 350% jump in transactions in the January-March period from the year earlier. In March, transactions from PPIs stood at 342 million, up 375% from 72 million a year earlier. This is very good for the economy as cashless transactions promote transparency, increase taxation compliance and reduce the spending on production of cash by the central bank.
This brings us to the conclusion of the short term analysis of the impact of demonetisation. Two points need to be made before we conclude. Firstly, Demonetisation has had a considerable social impact in the short term and public woes are inextricably linked with the economy’s performance as it was the unavailability of cash to the public which brought down inflation along with economic growth. Secondly, even with the extent of the problems faced by the people due to Demonetisation , the move has seen overwhelming public support chiefly due to PM Modi’s marketing and publicity strategies which touted the move as necessary and for the better of the economy. What remains to be seen is the long term impact of Demonetisation which will be the subject of Part II of this article series.
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