1. Consequences of demonetisation: All you want to know

Consequences of demonetisation: All you want to know

Expect some pain for unorganised labour, the service industry and the farm sector in the medium-term

By: | Published: November 17, 2016 6:19 AM
money The inconvenience was conceived in terms of the honest man or woman standing in queues to follow the rules of the game for the larger cause of unearthing black money.

When the bold step to demonetise existing 500- and 1,000-rupee currency notes was taken last week, the ‘little inconvenience’ that went as a suffix pointed to the adjustments that had to be made by households which had to convert these notes into deposits or partly back into cash with the new currency notes. The inconvenience was conceived in terms of the honest man or woman standing in queues to follow the rules of the game for the larger cause of unearthing black money.

It wasn’t hence exactly a demonetisation exercise—as it does not dispense with the value of a note—but one that simply replaces the existing notes with new ones, thereby addressing the issues of counterfeit currency and black money. In countries where currency notes are demonetised, the denominations simply disappear from the system. While it has been argued at various fora that we need to move away from a cash economy to a virtual one, this particular move does not really connote the same as theoretically one can, over a period of time, exchange X number of old 500-rupee notes for the same number of the new 500-rupee notes.

It is true that when such measures are taken there would be distortions in the equilibrium. Also, all possibilities cannot be addressed, and while the issues concerning households’ cash management was paramount in the government’s mind, there are other challenges that have come to the fore which need addressing.

The first is agriculture. This is one sector where all transactions are in cash and, given the values involved, involve the higher denomination notes. The withdrawal of the old currency notes has put pressure on the mandis; farmers are having problems in selling their produce as both the parties have to agree on the mode of payment. This has the potential to lead to localised shortages which would not really matter but for the fact that it can lead to price increases that can reverse inflation’s downward trend of the last few months. At the broader level, the fact that this sector is monetised through cash—and is mostly not tech-savvy—does flag the issue of the grand design of having a common market for agricultural products, which will not really take off until these loose ends are tied.

The second is the unorganised manufacturing sector that falls in the category of SMEs. These units work on the basis of cash, with purchases being made through this mode; all do not have access to credit and their creditworthiness could be of a lower grade. These units would find it a challenge to convert their currency—any time-lag in their operation can affect their functioning and hence there is a concern here. Wage payments, mostly made in cash—as labour in this segment is unorganised, and employed on a daily basis—also becomes a consequent problem. The shortage of currency notes and the restrictions on withdrawals have a short-term impact on these units which must strive hard to meet these requirements.

The services segment is probably the one that is impacted with greater intensity as the decline in business levels is irreversible. Restaurants, transport operators and trade in particulars are witnessing lower levels of activity which will not increase once normalcy is restored. Hence, unlike consumer goods, where there can be a deferment of demand to normal times, a meal excluded today will not be carried forward. The same could hold for tourism too where plans would not be deferred by regular tourists. Foreign tourism, in particular, will be affected the most as several tourist spots in the country do not accept cards and insist on cash, which becomes a nuisance for tourists. This is one area that will probably take some more time to recover, thus impacting overall production levels in the country.

Therefore, the mission to remove old notes and substitute these with new ones has to be accomplished fast so that the negative impact on these sectors is reversed. The government did time it well to ensure that it did not come in the way of the festival-demand season so that growth impulses would remain in the manufacturing sector. However, the present demonetisation period coincides with the harvest season which goes on till December; farmers will find it testing while selling their produce. There had to be a trade-off since almost any time-period would be associated with specific economic activity.

To the credit of the government, it must be added that the entire Jan Dhan Scheme laid the foundation for ensuring that everyone had access to a bank account so that monetary transactions are lowered and funds transferred to these accounts. However, this habit has not yet caught on. This has led to the present challenges in the farming sector in particular.

This clean-up operation would cause some dislocation and discomfort for the economic agents and households, but would, in one stroke, remove black money from the system, though the actual quantity will be known only by the end of the year. Black money is not held in just currency, but also in property and gold. Hence, this would be just one part of the story. In the medium-term, there could be correction in prices of property, though overall inflation should remain neutral as cash was not being used in a big way to spur demand of non-food items. The price of gold could decline to an extent, but given that we are price-takers in bullion, this will still be driven by the relation between gold and the dollar. GDP growth would get affected in Q3 and probably also in Q4, but should mean-revert in FY18. The speed of recovery will depend on whether or not the system stabilises after the 50-day period following the announcement. The government too may not really be affected much, considering black money would not come forward to be taxed and penalised.

Therefore, this exercise—probably the first of its kind given the scale—is more of a strong signaling mechanism, one that sends out a warning that the government will spare no effort to cull out black money in the system. It will definitely move people to the system of using plastic cards and other online and mobile applications in course of time and hold less cash. Currency will probably be held now onwards more for ‘precautionary purposes’ and not ‘transactions purpose’ or ‘speculative purpose’ as defined by conventional macro-economic theory. This will be good for efficiency.

The author is chief economist, CARE Ratings. Views are personal

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