Why rush? A gradual demonetisation would be more effective

The sudden demonetisation of Rs 500 and Rs 1,000 currency notes from Wednesday has caused immense exasperation. Professionals with disposable cash rushed to the ATMs to deposit thick wads of cash, while plenty of business houses, bureaucrats and politicians have been in spasms of worry about the stashes of cash that sustain their ventures into real estate, politics and a good life.

Usually policies to demonetise legal currency tenders are implemented in the event of massive counterfeit or hyper-inflation. Both cases see the legitimacy of the existing legal tender decline. The late 1920s, for instance, hyperinflation saw Germany replace the Mark with the Rentenmark. India faces none of those problems. The inflation is low, while counterfeit currency is not a critical problem. According to the prime minister, this is largely to combat corruption and black money.

The result is a policy that is a risky gambit with the conclusion depending largely on how the government chooses to pursue the policy to its end.

The short-term impact will most likely be a sort of crash-landing for industries, like real estate, jewellery, the bullion market and segments of the rural and informal urban economy, which rely on cash transactions. The rapid decline in the share prices of major real-estate developers is a sign of events to come. The uncertainty generated and the slow rate at which current cash streams are to be converted into the new legal tender will ensure animal spirits of affected industries wind down. Indeed, most significant real-estate deals negotiated in the past six months could be subject to renegotiation.

The industries that should go relatively unscathed are certainly those whose transactions are wholly legitimate – most service and manufacturing industries in the organised sector. However, if their upstream linkages (that is, raw material/commodity suppliers) or customer base rely overwhelmingly on cash. They too should suffer a short-term blip in sales or profit.

The worst-case scenario: enforced austerity

There is no doubt that the black money powers a huge segment of the Indian economy. Most estimates put the figure at north of 20% of the total economy – an estimated $500 billion. The current rate of conversion from demonetised tender to new legal tender afforded by the government remains pegged at Rs 4,000 per transaction till November 24. The Modi government has also given sweeping powers to the Income Tax Department in case huge deposits of demonetised tender are detected. Both these prove strong disincentives for unaccountable cash to be converted to new legal tenders or be deposited in the financial system. If the government strictly adheres to its deadline then a lot of unaccountable cash could simply be destroyed.

Will this be good thing? Perhaps the eradication of a good portion of the unaccountable transactions and wealth will make for good headlines. This may symbolise a respite of social justice in an economy largely unequal and unjust.

However, the fact remains that unaccounted wealth through its journeys into day-to-day consumption, the real-estate sector, jewellery and electioneering represents an important cycle of consumption and investment. Suddenly rendering large swathes of it illegitimate would amount to a regime on enforced austerity which shall take a good portion of estimated $500 billion cash economy out of the system. This means the cycle of reduced investment, consumption, deflation and reduced employment may soon begin in the sectors affected. This would certainly reduce the economic growth, and may end up very likely hurting the poorest – construction workers, petty restaurant workers and the like – for whom Prime Minister Narendra Modi claimed to stand up in his national address on Tuesday.

In other words, the best policy for killing unaccountable wealth is to turn it into legitimate wealth through government penalty, government confiscation or amnesty. The worst is to render it a non-entity – which maybe the case should such stringent limits on conversion to new legal tender continue.

The best-case scenario: gradual improvement

The best-case scenario remains that government – like with many other such programmes in India – keeps pushing the deadlines, and loosens the conversion regime so much so that the effective time period of adjustment inevitably stretches to a year or more. This allows the rural economy much-needed time for adjustment and plenty of stashes of black money to either appeal for amnesty, get confiscated or manage to be converted to new legal tender.

The government could be pushed into acting in this way by the detrimental impact of the demonetisation on the economy (as noted above) or the lack of adjustment to the new legal tender in the rural/semi-urban economy, which would cause immense voter discontent in states like Uttar Pradesh and Punjab that are soon to hold state elections.

In the event that such a gradual withdrawal of demonetised currency tenders takes place, it is likely that negative impacts are to be short term, and over the long term nothing significant will change besides forcing real estate players, jewellery players to slowly bring their methods into the legitimate domain.

If the government is truly strict – which is unlikely given past records of Indian government enforcing deadlines for various reasons – the scenario may be a regime of enforced austerity that inevitably causes hardship to both rich and poor. However, the best-case scenario – assuming government loosens its conversion regimen eventually – maybe a long-term impulse for real estate, jewellery, bullion and other sectors to slowly bring their methods into legitimate arena.

Akshat Khandelwal is a writer and entrepreneur based out of Delhi. His twitter handle is @akshat_khan.