The government’s move to suck out 86% value of money in circulation by demonetizing Rs.500 and Rs.1,000 currency notes will have far reaching implications on the Indian economy. Apart from the inconvenience faced by the general public, there is a great risk that this step may lead to serious crunch in the money supply. Apart from the promotion of cashless transactions there are many challenges ahead.
According to the data released by RBI on 9th November, there was more than Rs. 17 lakh crore of currency in circulation as on 28th October. About 86% of this currency was in the notes of Rs. 500 and Rs. 1000. The value of these currencies is about Rs. 14 lakh crore. There were 23.2 billion notes of these two denominations which would disappear from the system. So to bring the liquidity back at the old level, the government and RBI needs to pump new notes worth Rs. 14 lakh crore in next few weeks.
Where are The Notes
So far, the replenishment of invalid currency notes is much below to the requirements of the general public. That’s why we have seen serpentine queues of people in front of bank branches and ATMs. To ease out the liquidity system, it is very necessary that all the bank branches and ATMs should work with 100% efficiency. Unfortunately, so far, only half of our ATMs are in condition to work properly. As the size and shape of new notes are different from the old ones, the ATMs need to be calibrated. It is expected that all ATMs will be in working condition up to the end of November.
Moreover, it is an open secret that the government doesn’t have enough new notes. Therefore, it has set a withdrawal limit of Rs. 24,000 per week. But this limit is insufficient for a large section of the business and traders community due to which their normal day to day operations come to a halt.
Normalcy Will Take Time
According to the economist Saumitra Chaudhuri, the government may need until May 2017 to replenish the old currency. Chaudhrui says that Bharatiya Reserve Bank Note Mudran Pvt., which prints the higher denomination currency, has a stated capacity of just 1.3 billion notes a month. That’s with working double shifts. Raise this to triple shifts and it becomes 2 billion notes, which means it will need until the end of 2016 to replenish in value the 1,000-rupee notes. Security Printing & Minting Corporation of India Ltd., whose capacity Chaudhuri estimates at 1 billion pieces a month, will need several more months to meet the 500-rupee target, even if it joins forces with BRBNM, he said. The worse thing is that the printing of 100-rupee notes has come to a halt and which should be supplied more and more to ease the liquidity. It must be noted that the 500 and 100 rupee notes are the backbone of India’s $780 billion informal economy, which employs more than 90 percent of the workforce.
Growth Rate Would come down
How will it impact on economy, it can be explained by a simple fact that in India the circulation of currency is equal to the 12% of our GDP and today this circulation is to a large extent dried. It will have an adverse impact on India’s economic growth, at least in the short run. The cash crunch will hit a large number of cash transactions which will have a multiplier effect on the economy. If no one is able to sell or people refrain from buying from the supplier, it will kickstart a chain reaction. It is the informal sector accounting for around 40% of the economy which will be impacted the most, especially in rural India.
According to the former chief statistician of India Pronab Sen, the demonetization is likely to reduce GDP growth by one percentage point this financial year. Everyone accepts that the impact in rural India will be much more due to the sheer logistical difficulty for banks to reach out to depositors. It will also impact urban poor who depend on daily wages.
Some experts feel that the cash crunch is expected to paralyze economic activity, not only in the short-term but also in the medium term. According to Ambit Capital, there are chances that 2017-18 GDP growth may fall to 5.8%. From October-December 2016 until October-December 2019, Ambit Capital expects a strong ‘formalisation effect’ to play out as about half of the non-tax paying businesses in the informal sector become unviable and cede market share to their organized sector counterparts. According to the Ambit, it will impact especially those segments where cash-based transactions are the norm like real estate, unsecured lending, construction services and building materials.
Prices Would Come Down
This step will have some positive effects as well. It is believed that demonetization may bring down inflation in the economy, though for different reasons. Lower money supply will lead to a deflationary situation with too many goods chasing too little money. Also, it will play a positive role in curbing inflation in the medium term due to the lower money supply as unaccounted money used in sectors like real estate and higher education will be taken out of the system.
Tax Collection Would Improve
Furthermore, over the medium term, the demonetization will also discourage cash hoarding, leading to higher tax compliance and a widening of the tax base. And, it is believed that the dampening of economic activity is likely to lead to a rate cut by RBI. Economists are expecting rate cuts of 25-50 basis points over the second half of FY’17 itself.