November 8th, 2016 would go down in history as a day where the entire nation came to a standstill. Narendra Modi, in an address to the nation announce
November 8th, 2016 would go down in history as a day where the entire nation came to a standstill. Narendra Modi, in an address to the nation announced that 500Rs and 1000Rs notes would no longer be considered as a legal tender. It is clear that the government made this move to curb corruption and end the black money trade but let’s understand how this works. Let’s take a simple example, let’s say Mr A holds 1 crore of black money right now and assuming he has only 1000Rs notes. This would mean that he has 10,000 notes of Rs1000. Now with government abolishing 500Rs and 1000Rs notes, he would be unable to exchange it with the bank since the source would need to be produced. This is how demonetization works.
As per the RBI, 37 percent of the old notes have been exchanged or deposited in the banks as of November 18 and old notes close to 14,50,000 crore were in circulation before demonetization. There has been a lot of chaos in this regard across the entire nation. India, being a cash economy, is finding it tough to cope up with the current scenario. People in hordes have been found queuing up in ATM’s across the country and there have been altercations reported. Gas pumps have been at a major advantage owing to the higher cash flow. The need for the government to implement this comes across as a move to ensure that the black money holders were not alerted about demonetization since this would have nullified the entire agenda. While the move has been received well by the middle income groups, if not for the cribbing about standing in line, the move has majorly impacted the people at the lower levels in the country. People from the rural community, though possess legal earnings, accumulate their wealth or are involved in money lending. Despite the banking network being very active across India, money lending is still the biggest source of income for people in the rural community. The urban poor likewise, store cash for their daily use and demonetization has in turn affected their livelihood. The urban middle class however has found an Indian way of managing this situation which we refer to as Jugaad. Recently a startup came up with their app named “Book my Chotu” which would offer helpers to stand in queue by just a tap on your smartphones.
Let’s now look at the impact of Demonetization on some of the key sectors in the country.
Agriculture sector is expected to take a hit. Cash is the primary mode of transaction in the agriculture sector which contributes close to 15 % of India’s output. For instance, Plantation crops such as rubber, tea, jute, cardamom are seeing no wages paid to workers. Small-medium tea growers have few buyers now. Customer centric firms work mainly based on cash transactions and as a result, would have to face serious liquidity issues that could impact their growth for the upcoming quarter. Manuafacturing and Automobile Industry would also be affected on a short term basis but is not majorly affected since it would get back once the money circulation gets normalized. The passenger vehicle price more than 25 to 30 lakh may see a slowdown in this segment. Real Estate Sector would be majorly impacted since this sector possesses unsold inventory and there has also been a dip in the demand for cement in recent times. This move also comes at a time where the cement industry has taken a major beating due to the higher fuel prices. High end retail demand is likely to fall as it is expected that the impact on high end fashion retail and luxury would be more pronounced since discretionary demand in this segment would be curtailed. For instance in case of Quick Service Restaurants, although 60%-70% of the transactions are currently in cash, the impact is likely to be moderate due to the low ticket size of purchases and high likelihood of people adapting to plastic money.
The move of Demonetization also has a few beneficiaries as well, majorly being Banks. It is believed that the surge in cash deposits would help in bringing the interest rates down. Increase in CASA is considered to be the major highlight since this would help banks in lowering their funding cost and in turn bringing down their lending rates. This increase in CASA would be beneficial both in the short term as well as long term due to rise in money multiplier in the economy. Investment in Financial products is expected to go up since investors would feel apprehensive of holding cash which would mark a shift from physical assets to financial assets where the returns is also expected to be higher.
Deep diving into the issue, it is also to be observed that currency reforms by a government could be a blessing in disguise in the long run. Hawala networks which are considered to be the biggest threats to a nation’s security would be cut off from their funding sources since fake currency would go out of circulation in one stroke. Demonetization is also considered to have a positive effect on the fiscal deficit of a nation. The stock of black money’s impact on a nation’s GDP is considered to be very significant. Even if a portion of this amount, say 50% is withdrawn, the central banks can get rid of their liabilities and deposits that commercial banks would get will lead to a decrease in the lending rate and in turn the fiscal deficit. At the end of the day, the crux of demonetization is to ensure that countries move towards a cashless economy which would subsequently bring down corruption as well. For instance, due to black money existence in the nation, the US was losing its sheen built on Silicon Valley and the so-called even today existent American Dream. In 1969, US President Richard Nixon announced all bills above $100 null and void and the end result was a success. Take another case of Australia,in 1996, the government in order to curb black money crisis and improve security features on the notes, withdrew all paper-based notes and replaced them with long life polymer-based notes of the same denomination. This improved the life of the bills and helped Australia in becoming a business friendly country.
However the concept of a currency reform has also led to distress in the past. Take the case of the North Korea’s currency reform measures in 2010. Though the government’s intention was to basically control the rising inflation produced due to a shortage in the basic necessities, this policy of the government resulted in widespread panic. Higher prices drastically worsened the situation of the already affected standard of living of the workers which resulted in a wave of protests across Pyongyang. Though the move was mainly aimed at lowering prices and halting black market activities, it proved to be detrimental since the government did not understand the actual crux of the crisis which was basically severe shortage of food and other basic necessities. Consider the case of monetary reform of the Soviet Union in 1991. Michael Gorbachev, President of the USSR signed a decree on the withdrawal of circulation of the 50 and 100 ruble notes. This plan of the government was half baked, had a humongous negative effect which resulted in a loss of public confidence in the government. Consumer prices increased to about three fold and this move proved to be counterproductive with respect to the government’s objective.
History suggests that Demonetization, if not executed appropriately, might have a tremendous negative impact on a country and its population. Demonetization is certainly disruptive but it depends on the government to make sure that a country’s currency reform is successful in the long run and an appropriate impact analysis is made before taking any major decisions. At the end of the day, we need to contemplate if it is really the common man who is affected by demonetization or is it the people who are representing the common man?