Demonetisation: Too Many Pain Points

The impact of demonetisation is real. In the past couple of weeks citizens have recognised the importance of cash, or the lack of it. They may have also recognised the way black money touches every one. Black money has always been seen as some nebulous mound of cash stashed in Swiss bank accounts. It is not just that.

Every time a shopkeeper or a jeweller does not give a proper bill, black money gets generated. When cash is accepted to save tax of any form black money is generated. Whether this tax be sales tax or income tax.

The painful hardships of the last few days have quickly created two segments. One, the salaried few who do not have any other income and pay their taxes. Second, those who have income from various sources and do not pay their taxes. The degree of hardship varies for both. While the honest taxpayer has not been able to withdraw cash from the banks, the non-taxpayer has seen a major dilution of his wealth. Major dilution but not complete dilution. At the same time, the political focus has been on the decision to demonetise or its tardy implementation. Little attention has been given to its economic impact.

The economic impact has to be seen in short term (one to two quarters), mid term (3-4 quarters) and long term beyond a year. Demonetisation is expected to destroy 10-12 per cent of the total currency of Rs 500 and Rs 1,000 denominations.

Consumption is going to be hit starting with high-value luxury items, followed by durables and automobiles in the short run. This is an area where unaccounted wealth is most used. Real estate will see a real correction now, and government will have to look at revising circle rates downwards across the country. The medium and small manufacturing enterprises (MSME) sector is also going to be hit very badly as a large per cent of its transactions are in cash. Traders of all kinds dealing with the arbitrage of stock and cash will get impacted.

Transactions are the bedrock of an economy and they have shrunk to almost half in some sectors. The flip side is that debtors are down for most small businesses as unaccounted wealth holders would like to repay the outstanding in cash. Most MSMEs declare ‘cash in hand’ or petty cash of about 15-18 per cent; this will absorb the outstanding paid in cash. Small businesses with clean books may actually see a rise in their credit worthiness and cash in bank.

Reduction in transactions will surely affect money velocity and this can roll over to a mid-term impact in the economy. While economists claim that they can measure the impact on GDP due to money velocity, it is largely a theoretical exercise. Based on the quantity theory of money model which says that stock of money multiplied by the velocity of circulation is equal to nominal GDP.

Now, the overall stock of money has fallen drastically — 86 per cent of the stock in circulation was of high value currency notes that now stand abolished. Replacement of these notes is a 3-4 month exercise by conservative estimates. Therefore, discretionary spending will have a lag effect. How long will that be is anybody’s guess. At the least two quarters will surely get affected; how much is a trillion-dollar question.

Therefore, the pain in the economy will be there in the short to mid term, and in a way the government has pushed itself into a corner. Now, measures will have to be taken that economic slowdown in the short term does not lead to a long-term impact.

Interest rates will have to be brought down on existing consumer loans, not just facile reduction in prime lending rates or corporate loans. Discretionary consumer spending has to be brought back. Cutting income tax is another way but that will depend upon the fiscal deficit target, which the government is so fond of targeting.

It is wrong to assume that the cash deposit flowing into the banking system can be transferred to the government. Banks will have to do more over the next six months as they have failed the populace in delivering on demonetisation. Banks will have to bring the consumer trust back into discretionary spending. Automobile and personal loans sitting at 12.5 per cent will no longer be sustainable. Interest rates on existing personal and automobile loans have to be brought down to at least 9 per cent.

The government will have to do more now, if it wants to bring the economy out of this shock. The move might have been good politics and gained the government some brownies with the middle class but the economy may lose the momentum it has just started gaining.

While no time is right for a shock therapy, the momentum of growth has to be brought back again. Demonetisation is a harsh step at a time when economy is still delicately poised. If Laxman was harsh Ram was soft, the ruler has to be soft in his approach. Hardship of the common man has to be now supported by a softer approach. The economy can only handle a soft touch now.

Rajawat is a New Delhi-based policy commentator