Long term impact of demonetization on Indian Economy

On November 8, 2016 Prime minister of India Shri Narendra Modi announced the withdrawal of the 500 & 1000 denomination notes, which was about 86% of the total currency by value in circulation, with immediate effect. This demonetization move by the Government of India is a widely debated subject on its positive and negative impact. There is uniform consensus that in the short term the move had a negative impact on the economy. Currency crunch, long queues before ATM’s, drop in GDP by 1-2% in the successive quarters were the short term pains. Drop in interest rates as the banks became flush with cash, drop in inflation due to low consumer demand were the short term gains. But what is of importance is the long term impact of demonetization. 

In a report titled 'South Asia Economic Focus - Globalization Backlash', World Bank said eliminating tax evasion and corruption -- the most talked objectives of junking old 500 and 1000 rupee notes -- is "typically a demanding process involving multiple measures overtime.” Temporary setbacks notwithstanding, note ban will have a positive development impact in the long term as it accelerates financial deepening, foster financial inclusion and increase transparency, the World Bank had said. Answering a question recently on the demonetization and GST the IMF Managing Director Christian Lagarde said “Turning to India...we have slightly downgraded India; but we believe that India is for the medium and long-term on a growth track that is much more solid as a result of the structural reforms that have been conducted in India in the last couple of years,”. Describing the two major recent reforms in India — demonetization and Goods and Services Tax (GST) — as a monumental effort, Lagarde said it is hardly surprising that there “is a little bit of a short-term slowdown” as a result. Watch the full video here. 

We will now analyze the long term impact on various aspects of the economy.

Gross Domestic Product(GDP):

As evident from the above figure the  GDP growth trend is positive even after the demonetization. The following factors can contribute to sustained GDP growth.

• Collection of higher taxes will help in nation building like development of roads, infrastructure, transportation and many others.

• Increase in nation developmental projects will demand more labor and other skilled manpower which will give rise to employment opportunities.

• It will bring more business in taxation.

• Cash in system will boost educational loans and business loans thus bringing more opportunities.

Black money:

Wanchoo committee in its report on black money in 1971 had described it as a cancerous growth in India’s economy. Black money is the major cause for inflation, poverty, inequalities in purchasing power and unemployment. The ground work for fighting the menace of black money has been done by the government much earlier. The Black Money (Undisclosed Foreign Income and Assets) and Imposition of Tax Act, 2015 for Foreign Black Money, Income Disclosure Scheme 2016, Penalty on Real Estate Transactions undertaken in Cash exceeding Rs 20,000, Tax Collection at Source on Cash Sales exceeding Rs 2 lakh, Benami Transaction (Prohibition) Amendment Bill are some of the steps in this direction. 

All those who were hoarding cash were forced to deposit them in the bank accounts including benami bank accounts. About 3 lakh crore of unaccounted wealth returned to the banking system. Income tax department is investigating many cases and has already confiscated thousand of crores of ill gotten wealth and benami properties. 

The major sources of black money generation in the country used to be the following.

• Educational institutions through unaccounted capitation fees received in cash

• Terrorist organization funding through hawala rackets.

• Real Estate where large part of payment were made in cash.

• Hawala dealers

• Fake trust and charities that were used for money laundering and accepting donations in unaccounted cash.

• Corruption.

• Film industry where black money was a major source of funds

• Betting industry

By imposing accountability on all transactions  these initiatives  have struck at the roots of black money generation in the country.

Mainstreaming of the unorganized economy:

Many firms in the unorganized sector used cash payments and adopted unprofessional and opaque accounting practices for tax savings.  Most of them had parallel accounting systems.With demonetization the unorganized sector which used to deal mainly in cash will be forced to streamline the financial and accounting systems. 

More and more such organizations now understand the benefits of paying employee salaries and other payments through bank accounts. They now realize that by developing proper accounting systems they have better control on their costs and are able to analyze their business  for sustained growth and profitability. Many of the corrupt practices which are an offshoot of cash payments will reduce in the unorganized sector.

Digital / Cashless Economy :

Harvard professor Kenneth Rogoff, in his recent book ‘The Curse of Cash’ has made a case for a completely cashless economy and how monetary policy will operate in that scenario. Rogoff says reduction in currency in circulation will reduce corruption and crime. One of the major impacts of demonetization is the reduction of currency in circulation(CIC). In March 2016 the India ‘s CIC was 12.2% of GDP compared to 5% for Indonesia. As reported by the RBI by March 2017 India’s CIC dropped to 8.8%. At this level, India’s currency to GDP ratio compares well with a host of advanced and emerging market economies (such as Germany, France, Italy, Thailand and Malaysia). 

Digital Payments through UPI, Credit & Debit cards, Internet Banking, Mobile Wallets etc. have shown a steady increase post demonetization. The Govt. of India has set a very ambitious target of 2500 crores digital transaction by end of this fiscal. According to a report on digital payments in India, total payments via digital instruments are expected to touch $500 billion by 2020.

Tax Collection :

Another major impact of demonetization will be the increase in collection of direct taxes. With the evasion of tax proving to be difficult there is already an increase in number of income tax returns filed and advance income tax payments. Income tax returns filed in the current fiscal year saw an increase of 25 per cent and advance tax collections of personal income tax grew by 41 per cent. 

Demonetization and related initiatives by the Govt.  have  laid a strong foundation for structural and transformational reforms in an economy which aspires to be the third largest globally by 2028.

(The blog is based on many news and articles which appeared in Economic times, Financial Express, Business times and news from PTI.)