The government‘s clampdown on black money by voiding Rs 500 and Rs 1,000 notes could think wealth destruction could be pretty meaningful, according to a former Reserve Bank Governor.
Back in 1978, when the government resorted to a similar demonetisation, about 85 percent of currency didn’t come back into the system in terms of currency exchange, said C Rangarajan. Considering that number, he added, “I think wealth destruction could be pretty meaningful this time”.
Rangarajan, however, said how RBI treats the demonetisation — as wealth transfer or wealth destruction.
Touching upon the several pain points of the move which is being referred to as the government’s “surgical strike” on black money, Deepali Bhargava, Asia Economist, Credit Suisse, said that in the short term , sectors with heavy supply side cash chains such as autos and consumer will be affected. She added, “There could be more permanent disruption in the sectors like real estate, cement and jewellery where black money is likely to be more active.”
Nomura’s India Economist and Executive Director, Sonal Varma said demonetisation is a short-term negative for growth and expects growth to normalis after transitory shock subsides. “Nomura current projection is that growth will be about 7.3 percent in the December quarter, but we see a risk that it would actually be closer to 6.5 percent,” she said.
Varma added that “over a period of time it is definitely disinflationary”.
Below is the transcript of Sonal Varma, C Rangarajan and Deepali Bhargava's interview to CNBC-TV18's Latha Venkatesh.
Q: What are the estimates Credit Suisse is working with in terms of how much the Rs 15 trillion value of Rs 1,000 and Rs 500 notes will not come back to the system?
Bhargava: Historically, it does suggest that some parts of the currency gets permanently immobilised as a result of demonetisation. Historically, there was an episode which happens in 1978 and the impact on wealth destruction then was pretty limited, because the currency amounts that we were talking about then was pretty limited, so it was about 0.2 percent of gross domestic product (GDP) and this time we are talking about pretty big magnitudes, so we are talking about close to 10.5 percent of GDP worth of currency.
Last time almost 85 percent of the currency actually did not come back to the systems in terms of exchanging it with the new currency. If you were to work with this number I think wealth destruction could be pretty meaningful this time, but I think the question we are trying to essentially answer is, if it is really wealth destruction or a wealth transfer and the answer really lies in terms of how this gets treated on the Reserve Bank of India (RBI) balance sheet.
Q: The Reserve Bank’s balance sheets says in FY16 that it has Rs 17 trillion that is the notes it has issued that is it liability, if citizens destroy about Rs 2-3 trillion then the liability goes down. Will that be accounted for as an increase in reserves of the Reserve Bank and will it therefore be able to declare some dividend to the government, a special big dividend?
Rangarajan: To me this is a liability which is getting extinguished therefore on the liability side of the issue department it is coming down and therefore what will happen is a some amount on the asset side or equivalent amount on the asset side will have to come down. Therefore this is basically a balance sheet problem and it is not a profit in any sense of the term. The reduction in the liability side will be matched by the reduction in the asset side.
Q: There is no question therefore of the RBI being able to declare any special dividend. Separately Article 47 of the RBI Act says that surplus after meeting current expenses can be transferred, it doesn't seem to allow the RBI to touch reserves any comments on that?
Rangarajan: The interpretation is correct. I think the profits that are made by the RBI are essentially out of the current transactions. There is no capital gain or capital loss as far as the RBI is concerned. Therefore I would really say that there is no scope for any extra dividend to be declared to the government. Basically it is a simple adjustment on the balance sheet.
Q: Assuming that the RBI Act is amended to make the RBI pay something which is interpreted as a reduction in liabilities and therefore as a accretion to reserves of the central bank, how can the RBI transfer something as large as Rs 1,00,000 crore. What could be the modus operandi, how would the transaction itself happen?
Rangarajan: I really have to think through but I don't see it as a profit and therefore I don't think it will work that way. As you said it is a huge amount. However we do not know how much will be extinguished because it all depends upon how much money is not coming back in that sense of the term. Therefore we will have to wait and see. It will take almost another six months to find out.
Q: To take the argument forward in terms of impact on the economy, immediately when a large amount of what is maybe largely hoarded cash goes out of the system, what do you think is the impact on inflation? Do you see a big deflationary impact?
Rangarajan: Not necessarily, it all depends upon how and in what manner it was kept. Basically this decision of the government really immobilises a part of the unaccounted money kept in the form of currency. If it had been kept idle in the lockers of the people who have not accounted for the income or the money and it just now gets extinguished, therefore to that extent if it had been immobile before it will also be immobile now.
However to the extent to which this unaccounted income was circulating in the system, perhaps what will happen is that the difficulty in using this money, this unaccounted income which has been demonetised, to that extent it almost amounts to reduction in money supply. Whatever impact that lower rate of growth in money supply will have on inflation that effect will come. Therefore we have to wait and see how much of it is really does not come into the hand of the RBI.
Q: It is well known that the real estate sector works with a lot of unaccounted money or unbanked money, because of the real estate sector ally to it like cement could be impacted, the stock market is driving down even stocks like paint companies on the assumption that a lot of people who indulge in such discretionary consumption could be doing it with untaxed or tax evaded money. What is your sense in terms of impact on growth?
Bhargava: The best way to look at it is to look at it in the near term what happens and certain sector get impacted in the near term and what happens in the near term, so initial stage maybe more like supply side disruption, so like a natural disaster when transactions and activities get disrupted initially, but then eventually find their way around it and activities rebound, but perhaps there is a new lower normal and it doesn’t rebound to the level that was there earlier and some wealth does get destroyed permanently.
Initially, I think short term disruption will impact here sectors which have a very heavy supply side cash chains for example here a consumer sectors, your auto sectors etc, but there could be more permanent disruption in the sectors that you mentioned earlier, which is real estate, cement and jewellery as well where your black money is likely to be more active - - so barring the first round impact I think the longer term impact will be more sector specific rather than be felt on the economy as a whole.
Q: What do you assess as impact on growth and inflation?
Varma: Well, as far as growth is concerned I think it is clearly short term negative, but over a period of time things should normalise, this is more of a transitory shock. There are two things one is the short term cash shortage, which everyone is going to face and that is going to reduce the transaction volumes in general, discretionary consumption is going to get postponed, sectors which worked with more cash construction, the small and medium size sectors, two-wheeler purchases, second hand commercial purchases they clearly get impacted and it is going to take at least 2-3 months for things to start to relatively get back to normal and what it implies therefore is a shock to the economy and our assessment is that this shock could mean that growth in the December quarter — Nomura projection right now is that growth will be about 7.3 percent in the December quarter, but we see a risk that it would actually be closer to 6.5 percent.
Some of the shock could spill over into the March quarter as well, so we have a 7.9 percent forecast, which could come down closer to 7.5 percent, but beyond that I think one very positive aspect and the biggest positive from all of this is to the banking sector. The cash is circulation is going to come down. There will be significant deposit accretion for the banks, our estimate is close to 4 and a half trillion INR and given credit demand is weak, there will be a substantial deployment of this incremental deposit into government securities — so the issue of transmission we have had so far in terms of bank not lowering deposit lending rates, I think this scheme is going to give a big push to transmission, interest rates should come down whether or not the Reserve Bank changes and that is going to be a big positive for the rest of the economy and over time as tax compliance increases government gets more revenue, there will be scope for public capex as well, so our view is this is more a transitory shock restricted to the next 3-6 months beyond which we expect things to more or less stabilise over a period of time.On inflation more neutral in the short term because it is going to impact the cash shortage might have some impact, but the kind of conspicuous consumption demand is hitting real estate, gold these don’t really have a big weight in consumer price index (CPI) basket and even housing its rental it is not the value of housing plus if part of the informal economy the shadow economy actually becomes part of the formal economy, so they have to pay taxes than they might actually pass on some of the taxes as well to consumers. Over a period of time it is definitely disinflationary.
Q: Can this permanently affect behaviour? The real estate sector for instance goes through a serious shock so does the jewellery sector. Last time around the demonetization does not appear from the distance of 40 years to have had an impact on the tax behaviour. This move removes the stock of black money, can it impact the generation of black money, the flow in the future in anyway?
Rangarajan: This measure -- this is three target groups, one is those who have unaccounted money kept in the former currency. The other is those who maybe printing fake currency notes and the third is those who finance terrorism.
The last two are not directly impacting the economy. They are from totally different angle. As far as the unaccounted money is concerned, what this particular measure does is that to some extent it extinguishes the unaccounted money kept in the former currency but it does not deal with those people or does not affect the people who have unaccounted income who had unaccounted income and who had converted it into something else like real estate or gold. Therefore, it is only one segment of those who had accumulated unaccounted wealth is going to be affected.
Second question that you asked, which is relevant. This measure by itself does not do anything as far as accumulation of unaccounted money is concerned. This deal with a stock that has already been there. Therefore, if you want to address that particular issue of preventing the accumulation of unaccounted income there are other things that need to be done. This by itself will not do except to send out a signal that the government is concerned with it and therefore it may have an announcement effect as we call it in monetary policy. But otherwise, if we want to prevent further accumulation of unaccounted income, actions are required on different fronts.
Q: We have a lot of digitisation of accounts, which should allow for a much better audit trail than ever before in our country\\'s history. What do you sense is going to be the impact on the fisc for now and in terms of future behaviour?
Bhargava: One of the most important concerns on the fiscal have been the number of taxpayers and the share of direct taxes. The recent number suggests only one percent of the total population pays taxes and share of direct taxes to gross domestic product (GDP) has been falling. So it is about 5.5 percent of GDP. So to the extent, some of the money moves from informal to formal. It is definitely a positive on the fiscal side.
So to the extent that the parallel economy returns to normal -- it is difficult to assume that the parallel economy dies -- after the initial period of adjustment, you will see demand for physical assets going up. So the adjustment of physical assets will happen from cash to gold, so the demand for gold will go up and within the formal economy, what will happen is that the demand for financial assets like deposits will go up. So eventually, you will see a pickup in our financial savings and deposits, which will happen and you will see a scenario, which is overall very positive for bonds because without an increase in credit demand which is our expectation for the next one year or so and higher deposit growth you will see concerns on fiscal going down. So overall a positive for fiscal, I would tend to think from these two points. One, you get more less informal economy into the formal system and also you see higher deposit growth as well.
Q: What do you think will be the impact on the fisc?
Varma: As far as the fiscal impact is concerned, our rough estimate at this stage is that there could be an incremental increase in tax revenue of about 0.6 percent of GDP primarily coming through more tax compliance. Some part of the informal economy moving to the formal economy. We are being a bit conservative at this stage and just to mention not the entire increase in tax revenue that we expect will come in this year, a large part of that will come in next year. The size of the informal economy is obviously quite substantial at 20 percent and the tax rate on the formal is 15 percent. So you could say potentially the tax boost could be 3 percent of GDP but we are being conservative at 0.6 primarily because there will be some leakages. There will be ingenious ways to save taxes. People below 2-2.5 lakh cash deposit will not have to pay taxes. So keeping all those factors in mind, we expect this.
I think one important point here is that if you look at this demonetization in conjunction with goods and services tax that is coming up next year, I think clearly, the big theme that is going to play out in India is going to be the formalisation of the shadow economy and the benefit that brings along with it including greater tax coverage, tax to GDP ratio.
Latha: Let me give you the key takeaways from this discussion. The first one coming from Dr Rangarajan that those who are counting on a big manner, big windfall from the Reserve Bank of India to the government in the form of Rs one-two trillion dividend should think again that is not the way the accountant will account for it in the RBI's books, no dividend coming but there are other advantages.
Second takeaway is initially negative on the GDP itself, Sonal Varma calculates that the GDP in Q3 itself could fall by almost one percentage point from previous estimate and probably by about 0.5 percentage point in Q4 as well.
However, there is a kick-start that can come for the economy that is a third takeaway because the rising deposits and not so much demand for loans just yet because of the slowdown that the shock will result in. You could see deposits being invested in bonds and therefore a very sharp fall in interest rates, which may jumpstart the economy.
All our experts say that there will definitely be a deflationary impact because some money goes out of the system and that always brings down prices because the money effect is gone.
For the fisc, there is going to be a temporary advantage as a little more taxes get paid, our estimates are varying probably another Rs 50,000 crore at best could come to the fisc but the bigger advantage as Sonal Varma points out is that along with GST, there will be a larger formalisation of the economy and therefore in future years tax collections can definitely improve. One sobering thought which comes from Deepali Bhargava that after a point the parallel economy also will normalise, we will learn to live with a shock and then that economy will start not keeping hoarded cash but will start investing in gold and land. So in a bit you could see — after perhaps a temporary gap — gold and land prices going up.Get access to India's fastest growing financial subscriptions service Moneycontrol Pro for as little as Rs 599 for first year. Use the code "GETPRO". Moneycontrol Pro offers you all the information you need for wealth creation including actionable investment ideas, independent research and insights & analysis For more information, check out the Moneycontrol website or mobile app.