November 17, 2016    6 minute read

What Modi’s Demonitisation Means For The Indian Economy

The Monetary Polices Of Modi    November 17, 2016    6 minute read

What Modi’s Demonitisation Means For The Indian Economy

On November 9th, 2016, while the world reeled from the shock result of the US Presidential Elections, a nation of a billion faced an even bigger surprise.

The Prime Minister of India, Narendra Modi, in a rare televised address, dropped a bombshell, declaring that all existing currency notes of 500 and 1000 rupees (the equivalent of approximately eight and 16 dollars) would be demonetised, with immediate effect. PM Modi pointed out that the objectives behind such a drastic measure were to curb terror financing, limit corruption and discourage tax evasion on undeclared income, colloquially known as “black money”.

Expect The Unexpected

Many expressed shock at such a sudden and decisive step, as cash still rules supreme in India. Some 68% of all transactions in the country are cash-based, and the Reserve Bank of India has estimated that the banned currency notes formed over 86% of all currency in circulation.

But the move was regarded as largely positive, as seen in a survey by NewsGram, where an overwhelming majority, i.e. 82% of those surveyed, approved the measure. It was widely hailed by Twitterati and intellectuals alike as ‘revolutionary’. The Revenue Secretary, Hasmukh Adhia, even called it a ‘surgical strike’ on corruption. But not everyone was pleased with the move, especially the prominent opposition parties such as the Trinamool Congress whose leader, Mamata Banerjee, called it a “financial chaos and disaster on the people of India”.

The demonetisation follows a tax amnesty scheme called the Income Declaration Scheme which, after several extensions, was concluded on September 30th, 2016, as the final deadline for people to declare their assets and pay tax on the same. PM Modi had promised strict action against tax evaders after the end of a successful 2014 general elections campaign, and this is being viewed as the first significant move towards the same.

The Economic Impact of Demonetisation

Economists and policy makers remain undecided about the move’s long-term effects, but the short-term effects are already being felt in the week following the ban. Most banks have been forced to recall retired employees to deal with the heavy workload, with queues exceeding one kilometre in length becoming commonplace at urban branches.

As financial institutions and the public generally struggle to meet daily cash demands, the Indian economy is in for a shaky period. Experts feel that the real estate, commodities and retail sectors will be the worst affected in the short term.

68% of all transactions in India
are done in cash

A free fall in real estate prices is highly expected by most experts as they view real estate to be a popular vehicle for converting unaccounted income into real assets. The sector is expected to be the most impacted by the move, as the ‘Realty Index’ saw an 11.8 % crash on the Bombay Stock Exchange the very next day after the announcement.

Low cash liquidity may force prices to go down, resulting in higher demand in the long run, but experts feel that the effects of demonetisation will be felt for at least the next two quarters.

A Domino Effect

A fall in demand for luxury goods is also expected as a large portion of the transactions in the Indian luxury market is carried out through cash. Since luxury goods are virtually untraceable, it is a much sought-after method of converting unaccounted income.

Most luxury malls and retailers are preparing for the worst, as the cash crunch is likely to affect the impending New Year and Christmas sales. Most are thankful that the move took place after the festive season around the important Hindu festival of Deepavali, which sees massive splurges by Indian consumers.

Another possibility is a fall in short-term retail demand as much of the demonetised currency is held by small traders and the general public to meet day to day expenses. The sudden cash crunch may hit short-term retail demand the most, as the money is most likely to be deposited in the bank.

Traditional retailers across India have reported drops in sales, with textile retailers bearing the brunt of it as the ban has been enforced during the peak wedding season when they make most of their profits.

Precious Replacements For Cash

The risk of further demonetisation might result in renewed demand for cash equivalents, such as gold, silver and precious stones. The ever-popular dollar, euro and yen may also see a rise in demand, as wealthy Indians attempt to hastily convert their now worthless currencies into legal tender.

This may give rise to a black market that can fulfil these demands of the secretly wealthy, as the noose tightens on their domestic cash holdings.

Enter The Winners

Interestingly, there is a significant number of winners in this scenario as well – the financial technology and e-commerce sectors. Players in the nascent mobile wallet industry, such as One97 Communications’ PayTM, have recorded a 1000% rise in transactions over the period.

Several commercial banks have also reportedly begun concentrating their efforts on their electronic and app-based payment systems. As cash-strapped consumers look for suitable alternatives to cash, mobile wallet systems and payment banks look to capitalise on this opportunity through mass advertising and word of mouth.

Many banks also reported an increase in demand and time deposits. State Bank of India, the largest commercial bank in the country, received almost 830 billion rupees (around $12bn) in the five-day period following the ban.

The Road Ahead

The World Bank has estimated that the size of India’s parallel economy in 2007 was 23.2% of the country’s GDP. Another prominent Washington DC-based think tank, Global Financial Integrity, estimates that more than $94bn of black money has flown out of India since 2012 alone.

A significant portion of these funds is said to be in the form of high denomination notes, as they are easier to store, transport and transact with. The government hopes to take away these very advantages, by making the usage of cash expensive and difficult.

The move is largely seen as an impetus to PM Modi’s ambitious project “Digital India” which seeks to integrate a digital infrastructure into the present system. One of the goals of this project is to largely eliminate cash-based transactions by encouraging digital payment systems. The Reserve Bank of India has thrown its full weight behind a cashless economy by creating a new digital payment interface called Unified Payments Interface.

Setting A Large-Scale Precedent

It is interesting to note that no American or European nation has ever conducted a demonetisation operation of this scale. What is even more peculiar is that no country in the world, except for India, has gone for partial demonetisation, where only select currency notes and coins are demonetised.

Although the same measure was adopted by a previous government under PM Morarji Desai in 1978, the scale was minuscule compared to the one being carried out now. The Modi government could face serious supply concerns in the face of a highly globalised economy, but if implemented properly, the plan might just provide the necessary boost to the Indian growth story.

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