Prime minister Narendra Modi pulled off a coup that substantially enhanced his reputation as a strong leader, when he announced demonetisation on 8 November 2016. India lost 86 per cent of its monetary base because of the Cabinet’s decision. But was the government’s move to cripple black money (which effectively runs a parallel economy) right — or will it lead to a huge economic downturn?
The measure will be a memorable and transformational economic event of this century. I, for one, believe it to be a masterstroke of the PM, to destroy corruption in India and address the issue of counterfeit currency, which is the main source of terror financing. The black money in circulation is like a steroid in the economy, which spurs demand and gives a false sense of well-being. Even 25 per cent of this amount will be a bonanza for the RBI and when deposited in commercial banks lead to a rise in their deposit base. The deposit base of banks is expected to get a fillip of 0.5 per cent to 1.4 per cent of the GDP and financial savings are expected to rise on account of the switch from unproductive physical assets to financial assets. In the short term, though, GDP growth will take a dip.
An important aspect of this ongoing economic transition will be investment flow, by virtue of huge deposits. The cost of capital will come down for commercial banks and prompt a rate cut, leading to cheaper credit. This would mean cheaper home and education loan rates for retail customers, which in turn will drive demand. All of this, along with reduced interest rates for industries, will contribute towards capital offtake in the medium to long run, leading to more investments and in turn, capital formation. Was that not just what the economy needed?
Over the last two years, 245 million bank accounts have been opened under the Pradhan Mantri Jan Dhan Yojna. The share of these accounts is negligible in the total deposit base of the banking system, but have been increasing slowly. The demonetisation exercise will lead to more active use of these accounts and inculcate banking habits. A large part of the unbanked population will come into the system. Eventually, these initiatives will bridge the fiscal deficit. There will be a paradigm shift from the unorganised sector to the organised sector. The introduction of the GST will facilitate taxing commercial transactions that had so far evaded tax. It will increase the tax to GDP ratio by at least 3-4 per cent, enticing the government to think of reducing tax rates to give a fillip to the economy.
In the short term, sectors like real estate, building construction, infrastructure development and those predominantly employing daily wage earners will get pushed back. In the medium to long term, however, sectors that were the root cause of black money generation will contribute to capital formation. Ancillary industries will witness growth in the long term. It would not be wrong to say that GDP will grow at around 9 per cent by the end of 2019. I will not be surprised if it hits the magical double digit of 10 per cent. That’s where the economy will be moving in the long term.
The reduction in cash transactions will see a surge in demand for alternative forms of payment. Digital transaction systems, e-wallets and apps, online transactions using e-banking and use of plastic money will increase substantially. Demonetisation will also be a major blow to terror financing, naxalite issues plaguing the country and drug trafficking. In the long term, the Indian economy will emerge stronger, healthier and capable of sustained growth. However, short-term pain is inevitable for a long-term cure of a disease.
In a nutshell, the Indian economy has been provided a new lease of life. Over the next two to three years, India’s position on transparency and corruption will improve and hence its appeal to investors. I hope the government will put this bounty to good use, like housing for the poor.
