By P M Mathew
Bengaluru: The un-anticipated shock of demonetization, making 86 percent of cash with the public illegal has resulted in massive disruptions in the Indian economy. The demonetisation exercise, still dominating public discourse in the country, will have both short term and long term economic implications.
As it is already forecast by leading economists, demonetisation has already weakened consumption and GDP growth. The dip in GDP growth forecast is by at least 2 percent. As per a latest Moody’s report, “There is loss of wealth for individuals and corporates with unreported income, as some opted not to deposit funds back in to the formal financial system to avoid disclosing the sources of these funds.”
The economy has already borne the short-term costs such as the time people wasted in long ques, liquidity crisis in the informal economy, the worker layoffs and the many tragic deaths reported. Demonetisation of November 8 has affected the informal sector severely and it is going to be a drag on economic growth in the medium and long term. The informal financial sector is almost decimated.
The long-term effects of this monetary shock on India’s informal economy will be more severe than most analysts expect. A large proportion of tiny marginal firms may not survive the sudden loss of income. Driven primarily by consumption demand the Indian economy will be severely affected by the unexpected fall in disposable income of households and business. Post demonetisation, a scary situation is still existing among the lower middle class and even among the middle class in the country.
It is expected that wider economic costs are yet to come. Economic activities in rural markets have already slowed down. When farmers are short of cash agricultural labourers and local artisans are bound to suffering.
A cashless economy can only add up to the number of people at the margin of subsistence. Households and businesses were experiencing liquidity shortages as cash is taken out of the system, with a daily limit on the amount in old notes that could be exchanged for new notes. Corporates experience declining economic activity with lower sales volumes and reduced cash flows.
As Jean Dreze has forecast “The initial economic shock, already visible, can easily have ripple effects over the next four months. For instance, delayed sowing of rabi crops today could affect the harvest months from now. With employers, short of cash, labourers are likely to lose jobs. Macro-economic trends depend lot on expectations. If the initial shocks create adverse expectations, the economy’s growth trajectory could be derailed.”
This currency swap will not have much effect on the generation of black money through corruption. This will only attack a part of the black money stock and not the flow of black money in the economy. Broader policy action will be required to stop the generation of unaccounted wealth.
Some analysts are of the view that the poorly thought out scheme of demonetisation with its shoddy execution has missed the target. The much hyped up positive impacts of demonetisation are based on delusional hopes of the impact it might generate in flushing out black money and crushing the shadow economy.
All this is based on the hoard theory of black money which says that people hoard unaccounted wealth in liquid cash. But crooks know how to spend, invest, launder or convert it in one way or another.
As Raghuram Rajan, the former RBI Governor, says, “Since many people do not stack their black money in cash it is not that easy to flush out black money. Of course, a fair amount may be in the form of gold, therefore even harder to catch.”
They use it to deal in benami property transactions, invest in tax havens abroad, indulge in lavish spending in India or abroad or oblige politicians. It is said that black money is widely used by politicians in India to buy votes before election and to buy legislators after election. Only some money is lying “in jars or pillow cases” but going after this residual liquidity is like “mopping the floor under a shower.”
If the current disruptions and contractions in economic activity lead to a reverse operation of the Multiplier via reductions in investment, income and consumption, the long-term impact of demonetization policy will also be growth depressing. And thus, the Indian economy characterised by a high Marginal Propensity to Consume (MPC) and low Marginal Propensity to Save (MPS) is likely to be hurt more.
The other serious long termeconomic impactis related to the increasing digitalization and formalization of the economy. Saving workers and firms from the darkness of the black economy and leading them in to the light of the formal economy is a herculean task.
There is also the possibility that the sudden and un-anticipated demonetization exercise would likely to lower the faith of the populace in Indian currency. It may lead the corrupt, tax-evaders and even the upright citizens to have some liquid assets in non-Rupee forms. Now people may prefer to hold a portion of their wealth in gold and US dollar. This can, in the long run, lead to higher current account deficit and non-productive investments.
Again, in the absence of supplementary policies to curb black money the current demonetization exercise may induce people to channelize their money in other markets and countries.
The current demonetization exercise’s direct and indirect costs on the economy far outweigh its foreseeable benefits. As Prof Kaushik Basu says the long-term effects of demonetisation could be felt only in the next year. India’s service sector, which is contributing 60 percent of GDP is already feeling the heat.
The best way to curb corruption and black money is to clean up the legal system of several archaic laws and imposing stiffer penalty on corrupt public servants and black money holders.”
(Dr P.M. Mathew, professor of economics at Christ University, Bangalore for 36 years from 1979, has a distinguished academic career with senior leadership roles. Besides his M.A in economics from Kerala University, he holds Mphil, LLB and PhD degrees from Bangalore University. Dr Mathew is often invited as a resource person in economics by the industry, government and the academia and is a much sought after research supervisor. He also serves as a media economist contributing extensively to discussions and debates on current economic affairs. Currently Dr Mathew functions as a researcher, freelance writer , professor of economics and consultant lawyer. He can be reached at pmat2012@yahoo.com. )