Interview: Demonetisation is a large shock to the Indian economy – with little impact on black money

The drying up of cash has thrown the lives of millions of Indians in disarray. But many facing hardship support the government’s move.

In Barabanki, Uttar Pradesh, a farmer who did not have cash to buy seeds and fertilisers, said, “Now when rich people deposit money in the bank, the income tax people will catch them and put them in jail.”

GR Subramanyam, a merchant in Shirdi, Maharashtra, had no customers for his woollen garments. “What difference does it make if we suffer for 10 to 20 days?” he said. “We have to think of the country.”

But is demonetisation good for India?

Economists are not convinced.

The National Institute of Public Finance and Policy (NIPFP), a research institution under the Ministry of Finance, has published a working paper, which concluded that demonetisation is “a large shock to the economy”.

Prime Minister Narendra Modi has claimed that those holding black money have no option but to throw the notes in the river Ganga. But the paper warns that demonetisation might have little impact on black money, while leading to “a contraction of economic activity in the economy”.

In an interview with Scroll.in, Dr Kavita Rao, professor, NIPFP, and lead author of the paper, said the move is likely to suppress consumer demand, which might trigger other adverse economic effects.

Edited excerpts:

What will be the extent of the compression of consumer demand?
There is no way to put a number to it. One needs to know how much of the currency is extinguished (the currency that does not come back to the banks for exchange), and what part of it was being used for saving and what part was being used for transactions. We don’t have a reasonable basis to say much about these numbers.

But if you assume Rs three lakh crore is being extinguished, as is quoted in media reports, and say half of it is used for transactions, then the GDP [Gross Domestic Product] loss to the economy would be Rs 12 lakh crore, since the GDP is about eight times the currency in circulation. This amounts to about 8% of GDP. This is without factoring in the effect of the compression in demand in the economy.

What will the impact of compression of demand on the economy?
The first round of impact is not related to currency being extinguished (currency not coming back to banks). It is related to currency being wiped out until it is replaced by new currency. This will lead to a compression in demand across the board. Even if you have potential purchasing power in the form of rupees which can be converted into the new currency, you can’t use the old currency and you don’t yet have the new currency, so you can’t buy.

All the daily-use sectors get affected first. To top it up, any sector that is seen as non-essential, or luxury, too will get affected, because whatever currency you have you will want to use on necessities. Pretty much every sector in the economy gets hit. I would expect automobiles to be hit, textiles to be hit, I would expect pretty much everything to be hit.

What will be the second round of impact?
The second round of impact is when the currency is put back in the form of new currency. The impact depends on whether you are replacing the entire amount that is being surrendered by the public, or only a part.

The finance minister has been saying we (the government) want people to go digital, we want the banking system to play a larger role, then we are implicitly saying we will not replace the entire currency.

If the entire currency is not replaced, then there is a second round of compression of demand, because people have not changed their behaviours from dealing in cash to dealing in non-cash instruments. I may have money in the bank, but I might not feel confident enough to utilise it (through non-cash instruments). So in the transition period the impact will be felt pretty much across the board.

How long will be the transition period?
I would think it would be long, because you are talking about people learning new behaviours. A vegetable vendor will shift to PayTM, a shopkeeper will shift to swipe machines, but the consumer may take longer to shift. Will a daily wage worker receive wages on PayTM and make purchases on PayTM? Will he learn that in three months?

Will a lack of financial and digital literacy make the move to cashless transactions difficult?
We learn to look at cash as an agent in the economy. We learn that this note equals this amount. In India, currencies have different colours to help people comprehend what the value of a note is. Now, we want people to leapfrog to a situation where there is printed word in PayTM on your mobile phone, and you need to comprehend what it means, which means you need to know how to read.

The transition will happen. But even if you force it, it will take time to get large numbers of people to move to non-cash instruments.

There is a view that demonetisation will beef up balances in the banks and expand the availability of credit.
Even if you assume some credit is generated, is there demand for credit? The answer seems to be: at the present, not much. Remember the demonetisation drive is happening in a year when there has been low credit offtake. If there is a compression in demand after demonetisation, there might not be any takers for credit.

Even if banks want to give credit, they will have to push for risky assets. The interest rates will go down. Say, the bank is sitting on deposits. These deposits need to be used to earn income, or the banks will not be able to pay interest to the depositors. If there is no demand, first the interest rate on deposits will go down. Second, you would try to reduce the interest rate on borrowings, so that people take loans. If the overall demand in the economy is not doing very well, that might not be enough to stimulate a demand for investment.

What does the bank do? It has to find some agents to lend to, or it has to sit on money on which it cannot pay interest, or it will invest even more in SLR assets [statutory liquidity ratio] in the form of government bonds, for want of a better asset. None of this tends to be expansionary.

In the immediate aftermath, I don’t see a substantial expansion in credit which sets off a virtuous cycle. You are not looking at a scenario of private sector demanding more credit. The government can try to step up public investment or create SPVs [special purpose vehicles] to build infrastructure but we haven’t yet heard anything on that front.

In your paper, you caution against the ballooning of consumer debt. Could you please explain why?
There is a body of literature that says – and even intuitively if you think about it – your perception of spending is sharper when you spend in cash. If you spend through cards, the perception of spending is less, and people tend to overspend.

Now let’s say banks are sitting on potential credit. They have to translate it into realised credit. So they will encourage consumers to take loans, or there will be a wider network of credit cards. If your perception of spending on cards is less, this can increase consumer spending but also consumer debt.

You are changing behaviours and you might push consumers to more risky behaviour. When you don’t have a large social security network, and you don’t have bankruptcy provisions, you are pushing people to go into situations where life can get worse. As a policy for the government, you need to know when you shift to plastic, there could be consequences for the long term.

How will the move impact the generation of black money?
Unless you can move a large number of people to the digital part of the economy, you will still generate black incomes. There are two ways black incomes are generated. When you suppress your sales and purchases, whatever is your economic activity, it goes underground. Or you understate your sales and overstate your purchases, or you state your sales completely but overstate your purchases. By shifting to digital, the former might be controlled but not the latter. It is not as if where the world has gone digital, there is no black money.

There is formally no policy decision in the public domain on what is the proportion of money returned to the banks that will be remonetised. Are we aiming for a substantial reduction in currency, so people are forced to go digital, or are we aiming for gradual transition? This could influence whether the form of black money generation in the economy changes.

Let’s assume you put back bulk of the money in public hands. Then business can go on as usual and black incomes can get generated as usual. Here it is important to ask what we have done to make sure people have less incentive to go black? What the demonetisation did was one time wiping out of wealth. That by itself may not be enough to change people’s behaviours and perceptions on earning black incomes.

We haven’t convinced people that there is more merit in being in the formal sector. We as a nation still have to do that convincing.

Forcing people to go digital or letting business go on as usual – aren’t both scenarios bad?
Yes, what that says is demonetisation does not solve the black money problem. Not going down the remonetisation route amounts to putting large numbers of people on a torturous path to put a few people on the clean and narrow.

We are not saying “formal is better”, we are just saying “informal is bad”. Both are two sides of the coin. But to explain why formal is better means walking another mile.

What will be the impact on inflation?
In the very short term, the supply will contract, and the prices will rise. But in the short term, if the demand also drops, the prices might fall.

There is another big unknown hanging in the air and that is what the government chooses to do on the Goods and Services Tax. We have already given a big shock to the system. The players who have been really affected by the shock are the traders. Now if you want them to reorient their systems and get ready for GST rollout, we are perhaps asking for a lot.