As the whole nation debates the demonetization issue, there are two common threads where there appears to be an unanimity in thought process. The first such aspect that received near universal applause from all social groups is the support for the intent of cleansing India from the menace of black money. The Prime Minister was unanimously congratulated for the initiative from the beginning of the demonetization drive, although the clapping diminished with each passing day of hardship due to the visible lack of preparedness of the implementation process.
The second aspect of demonetization where near unanimity is that demonetization is going to be costly for the economy. The economic impact is expected to be significant, through the immediate shock from cash crunch and a more durable long term impact on economic growth through dampened economic activity, increased unemployment, inefficiencies due to wastage of man-hours and uncertainty induced risk aversion. The overall impact, as projections have revealed, can slow down India’s GDP by 1-3%, in the year ahead and in the process, threatening to derail India’s shining growth story.
Loss from Demonetization will be 2 to 4.5% of GDP
Some number crunching is necessary to place the full impact of demonetization in perspective. The Gross Domestic Product (at current prices) is estimated at Rs 136 lakh crore( Rs. 135760 billion or US $ 2 trillion as per the Handbook of Statistics on Indian economy, 2015-16). The estimated economic loss is around 1-3% of GDP in effect means that anywhere between Rs. 1.4 – 4 lakh crore may be the growth impact of demonetization , a ballpark measure of loss from economic opportunities foregone.
The other component of the loss will be in the form of unutilized wealth that is inherent in the value of scrapped Rs. 500 and Rs. 1000 notes not channelized into the banking system till end-December. We know that the currency to GDP ratio in India is around 12.5 %, so the total currency in circulation is roughly about 17 lakh crore. The demonetized currency is 86 per cent of it and is around Rs. 14.5 lakh crore. Studies on the cash component of the black economy puts it at 3-5% of the cash or anywhere between Rs. 50,000 crore to Rs 1 lakh crore. Thus the cash component that is white is 16 lakh crore of which Rs. 13.5 lakh crore is in Rs. 500 or Rs. 1000 notes. Now, we expect the demonetization drive will probably bring a significant chunk of it to the banking system. Going by past experience, though past is not a perfect predictor of the present, 20% of currency may not return to the banking sector. This will be roughly Rs. 3 lakh crore. Assuming that all black money is wasted and is not returned ( a very unrealistic assumption which discounts media coverage of ground reality) , still aboutRs 2 lakh crore of white money will not return to the banking sector. When seen in conjunction with the economic impact on GDP for the year, the estimated loss from both income depletion and shrinkage of wealth of ordinary citizens ( excluding black money) is a staggering Rs. 3.4 lakh crore to Rs. 6 lakh crore for 2016-17. The overall loss to the nation will be anywhere between Rs 2.4 to 6 lakh crore ( or 2-4.5 % of the GDP). This is likely to hurt the unbanked population more, thus the impact will be disproportionately higher on the poor. Some of it will be visible in terms of suicides , hunger and malnutrition among the poor or in the form of protests and disharmony in society, the rest will be the hidden tears in every household that the State may perhaps overlook in the quest of a digital economy.
In addition to this already scary projection, there may be other lasting impact through prolonged disruptions in the production cycle and rising debt burden among the already squeezed, hand to mouth, uninsured weaker segments of society. The windfall gain to Reserve Bank of India, as it stands currently, cannot be transferred as profits to the Government, as it boosts the reserves of the central bank. As a result, any major expansion in welfare benefits to the poor ( as compensation to the hardship) has to be funded through higher fiscal deficit or expenditure switching, the possibility of which seems rather remote.
Saving the economy from a slide
Perhaps due to the secrecy of the initiative, the Government did not rely on the huge talent pool of economists India has, both in public sector as well as in the private realm. The Government thus went ahead with demonetization, blissfully unaware of it’s short, medium and long term consequence. The Government continued to propagate “the theory of short term pain for long term gain” and the herd behavior of social media seemed to legitimize such initiative. The complexity of the mammoth economy was forgotten in the zeal to curb black money, and the sheer lack of a credible strategy started unfolding post November 8.
The good news is, with corrective policy measures, the adverse economic shock can be minimized. While this may not be good for those at the helm of affairs in the short run, as it will be interpreted as admission of inadequacy of the initial planning, but, can save the nation from significant hardship.
The first step should involve an announcement that till end March, 2017 the Rs. 500 and Rs. 1000 notes will be valid legal tender. This will ease pressure on banks and smoothen the transition. Assuming that those with black money have already acted as they are the ones likely to move first, not much damage is expected from this step. On the other hand, the wheels of the economy will start rolling smoothly and the output loss minimized.
Second, there should be a mobilization of currency and human resources temporarily to the unbanked sector, in rural areas where the bank account to population ratio is low. This may include the slum areas of urban segments. As those in cities have other means of transacting ( credit Card, Debit card and Apps), they should be deprived of cash, and the new Rs. 500 notes and other smaller denominations should be diverted to the rural belts. Temporarily, banking officials should be deputed to the rural areas as Banks in cities shall continue with minimal human presence. This will speed up the process of financial inclusion , a vision that guides the Prime Minister’s policy initiatives.
Last but not the least, the surgical strike on suspicious accounts should be strengthened through transaction monitoring and reporting at Banks coordinated by RBI’s anti-money laundering specialists. Information technology experts must aid the process of transaction monitoring and streamlined real time reporting . There will be a need to create task forces to accomplish these specific objectives, but the resultant gain is likely to be enormous. Those who have defrauded the Government, big or small, must be brought to book and there should be transparent initiatives towards the goal.
Once the damage to the economy is arrested, the Reserve Bank of India will have the bandwidth to take effective steps towards the creation of a digital economy, without forgetting those at the margin. As previous elections have shown, those who live at the margin are not necessarily marginal.
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