Dec 01, 2016 08:28 AM IST IST | Source: Moneycontrol.com
Impact analysis of demonetization in India
The term demonetization is not new to the Indian economy. The highest denomination note ever printed by the Reserve Bank of India was the Rs 10,000 note in 1938 and again in 1954. But these notes were demonetized in January 1946 and again in January 1978, according to RBI data.
Last week on November 8, when the whole world was waiting for the outcome of US presidential elections, Prime Minister Narendra Modi came out with his master stroke on corruption, counterfeit currency, terrorism and black money by announcing demonetisation and ceasing Rs 500 and Rs. 1000 notes as a part of legal tender in India.
The Reserve Bank of India manages currency in India and derives its role in currency management on the basis of the Reserve Bank of India Act, 1934 and a new redesigned series of Rs 500 banknote, in addition to a new denomination of Rs 2000 banknote is in circulation since November 10, 2016.The new redesigned series is also expected to be introduced to the banknote denominations of Rs 1000, Rs 100 and Rs 50 in the coming months.
The term demonetisation is not new to the Indian economy. The highest denomination note ever printed by the Reserve Bank of India was the Rs 10,000 note in 1938 and again in 1954. But these notes were demonetised in January 1946 and again in January 1978, according to RBI data.
Since less than 5 percent of population in India had access to such notes and most banks never had such currency notes, demonetisation did not have a big impact on the country. The decision was taken to curb the illegal use of high denomination currency which was used for corrupt deals in the country.
However, with the latest round of demonetisation, the common public and bankers are undoubtedly facing hardship since more than 85 percent of currency in circulation has been rendered illegal in one single stroke. Demonetisation is surely hampering the current economy and will continue to do so in the near term and will also impact India’s growth for the coming two quarters but will have positive long lasting effects. The question that arises is why demonetisation was required at this point of time. There are certain pros and cons of demonetisation.
One of the biggest benefits of this move is that it is going to drastically affect the corrupt practices. People who are holding black money in cash will not be able to exchange much as they would be in a fear of getting penalised and prosecuted by the authorities. Enemies of the country which are involved in counterfeit currency and terrorism will not be able to continue it further for quite some time at least.
The smuggling of arms and dealing with the terrorist will not sustain further as all of the money will be on record now. Secondly, the banking system will improve as it will slowly head towards a cashless society. Cashless society will increase credit access and financial inclusion. The existing white money of people will be known to the government and it will remain with banks so that it can be put on loan, and interest can be generated from it (though interest rates would fall) with a corresponding fall in Inflation.
Further Banking System will get a boost, as more than Rs 7-8 lakh crore base money (new legal money) will enter the system. However, it needs to be seen how much money actually remains in the system, once the cash withdrawal limits are eased.
Thirdly, it will reduce the risk and cost of cash handling as soft money is safer than hard money. It will also reduce government liability. Since every note is a liability for the government, the old currency will become worthless for those people, who choose not to disclose their income. Thus, this will extinguish government's liability to that extent. It is expected approximately Rs 5 lakh crore may come to the government in the form of extinguished RBI liability, taxes and penalties. This amount is enough to take care of India's entire fiscal deficit for one year or more.
It will also reduce tax avoidance. Whatever money will be deposited or exchanged, authorities will keep a track of it and they will be extra cautious in this period. Dealing in this period in sectors like jewellery and real estate will be on radar and those entering into Loan transactions may also undergo tax scrutiny. Search and Seizure activities of the IT Department will also rise to curb such malpractices. Limits have already been prescribed for reporting to the IT Department those bank accounts in which excess cash deposits are being made in this 50-day window (Rs 2.5 lakh in case of individuals and Rs 12.5 lakh in case of firms).
Importantly, in the longer run, tax and interest rates on loans are expected to come down as higher income tax collections arising from better compliance would offer scope to reduce rates over the long term. This, in turn, will drive up disposable income. This can give a positive impact on consumption demand in long term.
The liquidity squeeze caused by demonetisation will be negative across sectors with high level of cash transactions. Real estate, jewellery, retailing, restaurants, logistics, consumer durables and luxury brands, cement and some segments in retail/SME lending space will be facing short term instability. Those companies with high level of debt will face more pressure and can face loan defaults.
Secondly, there will be an added replacement costs of currency. We cannot ignore the increased cost of operating ATMs need to be refilled more often and also it will be a huge burden on banks. Initially, it is very difficult to create a cashless society as more than 50 percent of Indian population is not well versed with card transactions. Also for these initial months, it will be very difficult to make cash transactions of a higher amount. But the government is taking steps to improve liquidity into the system and reduce inconvenience as much as possible.
India is certainly going to experience "Acche Din" in Modi's regime. The decision of this surgical strike on black money was not taken in a day or two. Rome was not built in a day and similarly, this plan is the result of Prime Minister's meticulous planning and never ending fight against corruption. As a result, he has successfully made the right stroke at the right time.
Further, the penal provisions are hefty enough to ensure that corrupt practices will find it hard to take roots again. Despite certain short term troubles, demonetization is certainly going to give a boost to the Indian economy in the long run. As of now, all of us should stand and support this bold move of our Prime Minister and help those needy, around us.
(Pavan Kumar Vijay, founder corporate professionals)