It has been acknowledged as a bold move by many economists and citizens. The objectives of the policy were to root out black money, to discourage future generation of black money, and to root out counterfeit currency that was being used by terrorists.
I have been thinking about what could be the likely economic impact of demonetization.
Demonetization is likely to have the following impacts:
1) Reduction of black money: This manifests itself in two ways:
- New disclosures of unreported income and government seizures: So far Rs. 11.5 Trillion has been deposited (until December 6) in bank accounts. The Income Disclosure Scheme (IDS) which was operational before November 8 had yielded disclosures of more than Rs. 0.67 Trillion. Rs. 2000 crores of unreported income disclosures and Rs 130 crore of seizures have been reported from depositors after November 8 so far. The tax revenue to the government from this is likely to be Rs. 958 crores (as of Dec 7). This number is expected to rise as more disclosures and seizures are made. Future seizures of real estate, gold and other assets bought from unexplained sources of income is an area of great promise.
- Old currency not deposited back in the banks. This leads to a reduction in the liability of the RBI (India's central bank) and could create an extraordinary profit for the RBI. Given that the deposits in the first 30 days since November 8 account for 76.3% of the value of old notes in circulation on November 8, many analysts and economists feel that less than 5% of the old stock of currency will remain in private ownership on December 31. The RBI Governor has clarified that old currency not returned back will not decrease the liability of the RBI, and therefore will not be recognized as income.
2) Printing cost for the new stock of currency (net of scrap value of old notes): According to the RBI , there were 16.5 billion ‘500-rupee’ notes and 6.7 billion ‘1000-rupee’ notes in circulation on November 8. Each 2000 Rs note costs Rs. 3.73 to print whereas a Rs. 500 note costs Rs. 2.97 to print. Due to the movement towards digital and plastic transactions, we could assume that the currency required to run the country's business could be reduced by 25-50% (Note that 26% of the deposits made till Dec 3 have already been withdrawn by citizens. That number is likely to rise as withdrawal limits ease and currency is made more available). My estimate is that the cost of printing an adequate stock of new currency would be between Rs. 3000 crores and 5000 crores.
3) Decrease in value of housing and land stock: According to PropEquity research, (a real estate data and analytics platform covering over 83,650 projects of 22,202 developers across over 42 cities in India), valuation in the top 42 cities in India, sold and unsold, will take a tumble and fall up to 30 per cent ( approximately Rs 8,02,874 crores. If we were to include older urban housing, rural housing and land, the impact will be several times more.
3) Decrease in value of housing and land stock: According to PropEquity research, (a real estate data and analytics platform covering over 83,650 projects of 22,202 developers across over 42 cities in India), valuation in the top 42 cities in India, sold and unsold, will take a tumble and fall up to 30 per cent ( approximately Rs 8,02,874 crores. If we were to include older urban housing, rural housing and land, the impact will be several times more.
4) Impact on GDP: Demonetization is likely to effect national output in several ways:
- Liquidity Reduction: As the availability of legal tender to conduct transactions is constrained for few weeks after the policy announcement, it impacts the ability of citizens and corporations in conducting transactions. This impact will get reduced only when adequate supply is made available and/or when citizens and corporations move to account-based transactions. As of October 2015, 233 Million citizens were still 'unbanked'. Even at full-capacity, the RBI printing presses will not be able to replace 50% of the stock of old currency in the next 4 months. This will impact cash-sensitive industries such as retail trade, hotels and restaurants and transportation, and in the unorganized (including agriculture) sector. These constitute collectively more than 50% of the economy, by my estimates.
- Confidence Reduction: As liquidity got sucked out of the system in one fell swoop, consumers and purchasing managers become more frugal. Their confidence in spending their savings/income/profits gets impacted. This is visible in the latest Nikkei/Markit PMI Survey released in early December. The Nikkei/Markit Services Purchasing Managers’ Index sank to 46.7 in November from October’s 54.5, the first time since June 2015 that the index has gone below the 50 mark that separates growth from contraction.It was also the biggest one-month drop since November 2008, just after the collapse of Lehman Brothers triggered the global financial crisis.“The latest set of gloomy PMI figures for the Indian service sector shows that companies were heavily impacted by the Rs500 and Rs1,000 banknotes ban,” said Pollyana De Lima, economist at survey compiler IHS Markit. The reduction in confidence will manifest itself across all sectors of the economy but particularly in luxury goods, automotive, jewelry, home appliances, and capital goods. These sectors have seen a 20-30% dip in business since November 8.
- Activity Reduction in Construction: As real estate prices are expected to fall by 20-30%, construction of new homes will slow down. This will impact activity in the housing/ construction sector. As secondary transactions dry up in the remainder of the fiscal year, the registration taxes collected by state governments will also take a significant hit.
- Productivity Loss: As people line up in queues for many minutes/hours per week (particularly in rural areas), there will be a significant loss in labour productivity. This impacts the unorganized and self-employed sectors more than other sectors.
- Economic stimulation by increased government spending: The government can negate the impacts of the above effects by increasing spending. The Finance Minister, Mr. Jaitley has already proposed an increase in budget spending of Rs 35,170 crores to fund rural jobs development, the RBI Monetary Stabilization Scheme, farm subsidies and higher pensions. However this number is less than 1% of the quarterly GDP of India, and is unlikely to fully negate the other effects.
- Vicious cycle effects: Even when liquidity is restored to 'acceptable levels' in 4 months, the ripple effects of the GDP de-growth will continue for a few months as people adjust to the 'new normal' (lost jobs/income in the unorganized sector, lost wealth for asset holders, etc). Of course, every government official and banker will try to convince the public that the future will be more rosy as the past, so that these vicious cycle effects are negated.
Various economists have indicated a 50 to 200 basis points reduction in GDP growth due to demonetization in FY'16-17. Due to the magnitude of the effects stated above, I personally believe that the impact will be much more. Even if the GDP for the 140 day period in FY'16-17 after the announcement reaches the same level as the GDP during the same period last year, the GDP growth for the year will have been impacted by more than 290 basis points. In my mind, it is likely that GDP impact is more than the gloomiest analyst's estimate (Ambit Capital's estimate of 330 bps impact in FY'16-17). Even if we assume that GDP growth is impacted by 330 bps in FY'16-17, that impact would total Rs. 4,95,000 crores!! Considering that taxes in India amount to 17.7% of GDP on average, the government's revenues for the last 2 quarters of the year will take a significant incremental loss.
Other Impacts: While I considered the impact of demonetization on future corruption and counterfeit currency, I believe these impacts will be short-term and insignificant. Counterfeit currency in circulation is estimated to be less than Rs. 400 crores. Counterfeiting will continue to be a challenge as counterfeiters find ways to duplicate the new currency.
What should the government do now?
- Increase government spending in the rural and unorganized sectors. The 37,000 crore relief being planned may not be enough!
- Increase social and welfare scheme funding to protect the weaker sections of society
- Aggressively mine data from bank depositors to identify tax cheats. Raid premises to seize gold/jewelry/property documents that have not been disclosed in tax statements
- Ensure that there is a taxable entity (PAN number) associated with each piece of real estate. Follow up with step 3.
- State governments should reduce property registration fees and property tax to prop up the secondary market, and to disincentivize creation of future black money.
8 comments:
Couple of (not necessarily connected to each other) things I wanted to share.
1. A lot of (minor?) luxury businesses will suffer due to reduced "black" money. Stuff like eating out at a fancy restaurant, spending more on the interiors of the house, buying branded stuff, etc. are spends that, for many people, go from their "black" money. As a people culturally programmed to save, we tend to be more prudent with our white than with our black. Not wanting too much currency lying around and a feeling that it is easy money contribute to the generosity when it comes to spending black. With everything white ( or with less black), much of this will be deemed unnecessary and these businesses will get affected and hence an overall slow down of the retail/regular business. A cultural aspect that will have an impact, though how significant, I do not know.
2. I think a lot of money and effort needs to be concentrated on getting the illiterate population down. Literacy, in this case, would be what is required to go towards a cashless society, which means know how to use banks, credit/debit cards, aadhar card, apps like paytm, being able to check their passbooks, understanding passwords and security, etc. If this demonetization drive has to be more than just a one-off meaningless exercise, the final goal should be for India to go completely(or mostly) cashless! Otherwise, this is a wasted effort at best!
Fantastic & thorough analysis.
The government should also target the cash usage in the political process & simplify the tax code that could lead to higher tax participation.
Thanks Sanjay, Nitya.
I have now updated the numbers based on latest available information.
Hi Raj,
Very good analysis.
Demonetization should improve value of INR against USD
Yogesh Diwan
Raj,
Good analysis and good to see data being put together.
Some points to consider:
1. Where does the 400 crore on counterfeit come from? They say that for every note caught, there are 26 not detected. Now even that number is suspect. Also counterfeits will keep circulating in the black markets (esp. property) and will never see a bank - so hard to say how many are there.(hence hard to put a number on it)
2. Just because a large fraction has come back in, it doesnt mean all is kosher - some guys will be scrutinized for large deposits and that can happen 3yrs from now too.. so that window is larger.
3. Its easy to quantify costs - what about benefits? just because they are harder, do we ignore them and their order of magnitude/scale? What is the value of going digital? What is the value of reducing friction in transactions? What is the value of making it harder to escape taxes and hence improve compliance?
I think everyone will agree that the implementation has been poor but the real question now is - how do you make lemonade out of the lemon handed to you...
Jay: I largely agree with your comments.
1) 400 crores is the Finance Ministry estimate of counterfeit currency. It could be higher. But my contention is that the new notes will also get counterfeited. The same Swiss paper company that supplies India, also supplies Pakistan.
2) As I do point out, the government should chase the large deposits that have been made using unexplained sources. They should make it mandatory to link PAN cards to bank accounts, especially those with large deposits.They should also chase the other forms of black wealth (real estate, gold, etc) from high-value depositors. There is great promise in that area.
3) I agree that the movement to digital currency will lead to reduction in costs. I factor that in the lower printing costs for the currency stock (by assuming only 50% of the currency stock will be replaced). However there will be plenty cash sloshing around for black money hoarders to do their thing :-(
Agree with the positive spirit of making lemonade from lemons !
Raj,
Great attempt and putting together cost - benefit of the exercise. This is a once in a lifetime event and any serious economist would be drooling at the amount of learnings and lessons this could bring to him. Instead they are busy passing judgement from day one and even quantifying outcomes, even though outcomes are so dependent on human behaviour and tough to make a serious prediction.
I have been trying to put my head around, what constitutes success and what is the right framework to evaluate it. Infact the boundaries of this program also need to be defined clearly before a framework to evaluate it is ready. You bring out lots of important costs and benefits, but I am not sure that its comprehensive. Here are some points for your to consider.
1. How do you account for more people coming into the tax net? When and how will we know what that number is ? Should we factor them in based on additional tax collected from them over the years or not
2. How do you account for addition collections at local levels - including cash payment towards NPAs, municipal corporations, dues legal dues etc etc.
3. I am very skeptical of taking real estate at market value and the decline in that. Most people are talking about a decline in secondary prices and perhaps a better buoyancy in the primary market (loan driven). The mark to market for secondary is in any case is dubious and fictitious and its incorrect to take it. The assumption of secondary market pricing is generations additional cash or black income over the years to sustain that price - in which case we are talking going back to the scam days and an economy which reflects that.
4. What about impact of the supposed lowering of interest rates ?
5. One the cost side - how do you account for businesses going bust ?
6. How do you account for lost labour and wages and lives and even families going hungry at the margin ?
7. What if the program was extended to a tax on all cash withdrawals above a certain level by companies (which are not set off against book entries).
8. The cost of printing notes is easy to evaluate but there is also a study by Mckinsey on the cost of managing cash in the economy - if I remember right its 0.5% per annum. What about changes to that number ?
9. What if even 5-10% of the informal economy decides to go formal - how is the GDP calculations change as a result of that ?
In my humble view, its going to be a long time before any data will be available. Its time to observe and learn. For those who want to form an opinion, they would have to go with believes rather than analysis.
Hope its food for thought.
Ashish: You make several good points.
1) Indeed the tax base is expected to widen in the long run, and the benefits could be significant. Even levying a presumptive nominal tax on small vendors can increase the tax collections by a significant amount.
2) I agree that NPA reduction for banks and payment of dues for government bodies could be a significant benefit. But one could also argue that a significant portion of that money was black money that now stands laundered.
3) Better buoyancy in the primary real estate market in the scenario where secondary market goes down 20-30% and has a significant reduction in deals, seems unlikely in my opinion. Mark-to-market is relevant for people who hold real estate investment assets because sale is the only liquidity event.
4) I will be talking about potential lowering of interest rates in a subsequent article on banking. Just a point to note: Aggregate deposits in the banking sector were 102 trillion before Nov 8. They have increased by 8 trillion in the past month. A significant part of this increase is temporary (because people can't draw down their own money). The maximum increase in deposits has been in FDs, that are not low-cost liabilities for banks. The interest impact in the long term cannot be more than 50 bps. In a relatively under-leveraged economy such as India, it is unlikely to have a major impact.
5) Agreed. Businesses are going bust and we cannot account for it just in terms of GDP loss. People are losing their jobs and this has significant long-term social impact.
6) Agreed. Unorganized labour and self-employed vendors are getting impacted significantly. I have recommended the need to step up social welfare schemes.
7) I will not be able to opine on alternative taxation regimes since I know very little about the topic. However moves encouraging the formal economy to use less cash are certainly beneficial.
8) I have not seen the McKinsey study. However considering that it costs only Rs 3 to print each note, and generally the spoilage is not significant, the cost of maintaining currency stock is unlikely to be significant.
9) India does add the economic activity of the informal sector to the GDP. Anyway I am not concerned about calculation issues...am more concerned about real economic activity.
I agree that the benefits could be extremely long term and the costs are short term. Unfortunately for the poor people at the fringes, the day of reckoning is in the short term. I also feel that taking a decision without having any clue about the magnitude of the so-called long term benefits is a foolish decision.
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