Demonetisation as a policy instrument remains relatively unknown, its impacts least analysed. The sudden invalidation of the 1,000- and 500-rupee currency notes elicits many concerns; but with little relevant history to rely on, there are only some sketchy narratives on channels through which it could impact. This gap provided space to its supporters to downplay the associated risks and project it as a ‘grand reform’ with long-run benefits. Critics argued it is a blunt instrument and could potentially inflict significant collateral damage in an economy where more than 90% of transactions are in cash, while the withdrawn currency was as much as 86% of that circulating on November 8.
The sudden act halted trillions of daily cash dealings; rebooting operations was never going to be easy. Time was of essence, therefore, as millions engaged in farming and the informal sector risked losing incomes without much buffer of savings. The fear being any mismanagement of swap operations at such a gigantic scale might not just undermine an ongoing recovery but even push those surviving at the margin into distress.
Within a fortnight, these worries came to the fore. Once RBI released a remonetisation update, two things became very clear: the central bank was least prepared to print the volumes demanded; loss of control over pace of currency-supply meant economic disruptions would be far longer than anticipated. Two, the government’s assumption about trapping black money worth an estimated R4-5 trillion prove optimistic—people managed to deposit cash at banks at a furious pace, thereby depriving much-needed fiscal space to the government for higher social spending to offset income losses of the poor.
Braving these odds, nonetheless, the government claimed disruption would be contained and activities normalise as soon as swap operations ended. Look no further than RBI’s GVA growth projection for evidence: a trivial 15 bps reduction on account of demonetisation—a mere loss of R150 billion! It is equally underwhelming that this was the consensus view of the monetary policy committee. Most haven’t accepted RBI’s assessment though, lowering real GDP growth up to 100 bps or more, estimating larger negative hit to discretionary consumption. Very few have taken a call on possible recession as this threshold requires credible evidence of growth decline beyond two quarters; the underlying assumption is that discretionary spending will resume once remonetisation completes.
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In subscribing to this simplistic framework, perhaps the dynamics with potential to create serious uncertainties is downplayed. This can be characterised thus. The government’s panic reactions in pursuit of black money: outmanoeuvred by hoarders, it resorted to frequent rule-changing; threatened to set-off empowered taxmen for hunting illicit money from fresh bank deposits; and worse, encouraged fellow citizens to report on black money. Such words and actions become a source of anxiety—conditions that breed uncertainties. Topping all this is an overstretched banking system, blamed for collusions and derailed from normal lending operations.
Pull all these together with slow-paced remonetisation, a deliberate push towards rapid digitisation of payments and what you have is a potent cocktail of uncertainties that can trigger withdrawal symptoms in discretionary consumption and further deter investments. Growth then risks settling down to a new normal—a much slower pace as fears of leaving a trail forces discretionary spending to shift overseas or silently die out, while businesses do not plan new investment. Superimpose upon this the initial economic conditions—a consumption-driven economy, investment and credit growth in trend decline, faltering exports, unresolved non-performing assets, stretched balance sheets of banks and corporate, underutilised capacities and external environment turning adverse. Surely a recession is not unthinkable with fears that heightened uncertainties could prolong its duration.
But what should worry more is if the debilitating impact upon the informal economy opens fault lines for a structural slowdown. Analysts are strangely underweight on this, though fully cognizant that tiny balance-sheets of a million small enterprises, operating at wafer-thin margins, bear the brunt of demonetisation because of excessive cash-dependency. The significance of this cannot be ignored: when switching to the MCA21 database, the central statistical organisation (CSO) underlined that a large proportion of GDP value additions in recent years accrued from a million small, informal enterprises whose trends the leading indicators do not capture. This vibrant segment is hit with a sledgehammer, without an effective framework to restart.
A simple analytical construct can elaborate. Divide these informal businesses into five broad categories, with different permutations and combinations: A sources inputs from, and sells its produce/services within itself; B buys inputs from the formal economy but sells its output to the informal one; C purchases inputs from both formal-informal segments, while selling only to informal sector; D sources inputs from formal and informal sectors, also selling to both; and E buys informal sector inputs, while selling only to the formal one.
All transactions are in cash. The balance-sheets of all five categories are subjected to varying degrees of stress, which along with margins, will determine capabilities to survive a demand shock lasting above two months. A would likely suffer the worst and E the least as demand for its output lies mostly in the formal sector. A, B and C category firms that cater mostly to wage-earners may face harsh demand constraints from falling wages and employment in these segments. These firms either risk closure or scaled-down operations from costlier informal credit and build-up of uncertainties associated with compliance costs. Likewise, D and E could face slower formal sector demand and competition from cheaper imports even as operating costs rise.
Many supporters want formalisation of activities for gaining efficiency and broader tax base. If that is so, the government may have to either let these units simply die or gradually formalise these with interim financial support. But there’s no policy clarity. If uncertainties persist, these risks could turn contagious for thousands of formal sector MSMEs who depend upon inputs as well as final consumption demand from the informal economy. Incorporating a real estate and housing slowdown along with discretionary consumption and private investment under the cloud of policy uncertainty, conditions could worsen. Post-remonetisation, if the number of strained balance-sheets of such firms crosses a critical mass, the loss of demand could be quite significant and become a source for structural slowdown.
The current situation desperately needs hard data on all this. There is no reliable, high-frequency unemployment data for quick impact assessment; most leading indicators cover the larger, formal economy. All that is available are press reports of businesses either scaling down operations or shutting some activities altogether; insufficient to judge if in aggregate this could form a critical mass that materialises into a structural slowdown. Data that captures informal sector trends, e.g., Annual Survey of
Industries and corporate filings under MCA 21 for FY17 will arrive with a two-year lag. How can this gap be filled?
The government should consider a quick survey as soon as remonetisation ends to assess damages to the informal sector. If not contained with constructive policy interventions, the expected short-term pain could well morph into an unanticipated longer-term one, in which large masses of vulnerable workers are pushed below the threshold of absolute poverty, hollowing out the economy. The economic gains from 25-years of reform would then be lost in a single stroke.
The author is a New Delhi based Economist