Demonetisation – a Needless Surgical Procedure Performed on an Unhealthy Economy

The price of demonetisation’s “success” is now clear – slowing economic growth. What makes matters worse is that India has made very little headway in solving its twin balance sheet problem.

Rs 15.28 lakh crore out of the Rs 15.44 lakh crore in currency that was rendered invalid on November 8, 2016 has come back into the Indian banking system. Credit: PTI

Rs 15.28 lakh crore out of the Rs 15.44 lakh crore in currency that was rendered invalid on November 8, 2016 has come back into the Indian banking system. Credit: PTI

The patient was the Indian economy.

Among the 176 countries that have been ranked by Transparency International on a scale from 100 (very clean) to zero (highly corrupt), India ranks in the second half of the list at 79, with the illegal money of sizeable proportions.

The central government, which was elected on the promise of a cleaner government, is worried about coming to power again. With the impending election two years away, it had to do something drastic: a much-dreaded surgery with uncertain consequences.

That was the November 2016 decision of demonetising Rs 500 and Rs 1000 currency notes in order to curb black money.

No doubt, the demonetisation exercise had to be kept a secret for its full effect to be realised, ruling out any possibility of wide discussions and weighing of pros and cons. It is reported that even the chief economic adviser was caught unaware, though the Reserve Bank of India (RBI)’s top management was prepared for it.

Unrealised windfall

The demonetisation was clearly aimed at eliminating black money. It was thought that some Rs 5 lakh crore (Rs 5 trillion) would be declared illegal; RBI’s liabilities would be extinguished, giving rise to larger than usual annual profits and they would be turned over to the government as dividend for funding planned social welfare schemes and infrastructure projects.

The windfall did not materialise.

Early this week, it was announced that of the estimated Rs 15.44 lakh crore (Rs 15.44 trillion) of currency that was rendered invalid due to demonetisation, Rs 15.28 lakh crore or Rs 15.28 trillion has come back into the Indian banking system. Does it mean that the so called “illegitimate money” that has now been legitimised was, in fact, a close 99%? The unreturned money of about Rs 0.16 trillion is just 1%.

The question is: was the team of surgeons, minimum in number for secrecy purposes, competent enough? Or if a member expressed a contrary view, was it given due consideration?

That will remain a secret for some time.

For every fait accompli decision, there are always two views, one supportive and another opposed, whether one likes it or not.

Is the achievement worth the effort?

The price of “achievement” following the November 2016 demonetisation has now been measured. Economic growth rates have been falling. Though not big falls and of course the growth rates are positive.

In the April-June 2017 quarter, the gross domestic product (GDP) grew at 5.7% – a three-year low, much below the 7.9% GDP growth in the corresponding quarter of 2016 and lower than 6.1% recorded in the January-March quarter of 2017.

It is a clear downward trend.

GDP growth can always be attributed to not one but a combination of factors in a developing economy. The most important component of aggregate demand is domestic consumption. Falling demand is also influenced by decreased external demand for domestic output and competitiveness of India’s exports and, of course, investment demand.

The government’s chief statistician was in a hurry to point out that it would be incorrect to attribute it to ‘demonetisation effect’. He laid the blame on the impact of GST roll out on the industry.

The government should have handsomely accepted the failure.

Also read: Demonetisation’s Failure Won’t Hurt Modi, He’s Already Changed the Narrative

All along, ever since the November decision was announced, the growth momentum has been halted. The fears of economic doom have gripped the nation. The middle class has been rudely shaken.

The International Monetary Fund (IMF) in January 2017 updating the earlier October 2016 World Economic Outlook lowered its estimate of India’s growth. It said India would grow only at 6.6% as against its earlier estimate of 7.6% on account of the “temporary negative consumption shock, induced by cash shortages and payment disruptions associated with the currency note withdrawal and exchange initiative.”

The IMF hoped demonetisation would strengthen India’s institutional framework by reducing tax avoidance and corruption and would support efficiency gains.

The World Bank, while echoing the IMF’s view, made it clear that the reason behind the move was “to curb corruption, tax evasion and counterfeiting”. It added the move would “broaden the tax base” and help revenues which will “eventually go up, besides reducing the size of the informal economy.”

The finance minister Arun Jaitley is now keen to highlight tax avoidance, broadening the tax base and reducing the size of the informal sector and other likely gains, and continues to downplay the main purpose behind the demonetisation decision. “People with inadequate understanding of how to tackle black money linked note ban with money returned to system,” said Jaitley, adding “deposits in banks don’t legitimise” black money.

“Money has now been identified with its owner”

It is touted that not only has liquidity been restored but that now there is an excess of it. Bhupal Singh and Indrajit Roy of RBI in their working paper on ‘Demonetisation and Bank Deposit Growth‘ note an unusual increase in cash deposits of about Rs 1.7 lakh crore and the excess of the order of Rs 2.8-4.3 lakh crore.

The interest rate has fallen with the RBI cutting repo rate by 25 basis points. The commercial banks should pass on the full portion of rate cuts to borrowers if the effects of transmission mechanism are to be fully felt and benefits realised.

Last month, RBI deputy governor Viral Acharya referred to an unintended outcome of demonetisation decision: a benefit indeed. It is the shift away from bank deposits to financial assets.

Bloomberg reported that funds have moved from low-cost current account and savings accounts to other financial instruments. Mutual funds are among the beneficiaries with their assets at Rs 18.96 lakh crore as of June 2017, compared to Rs 16.28 lakh crore in October 2016.

The FM is keen to get on with his work, apparently, he does not want to spend any more time discussing why the windfall did not materialise and why only one percent of the Rs 15.44 trillion liabilities were extinguished.

He has no time to waste on the elusive black money.

FM’s job is now cut out

The latest State Bank of India Ecoflash of September 1 notes that the incremental bank credit in the current fiscal year is declining. It is now less by 1.37 lakh crore from last year’s figure during the corresponding period of April to August: it is a negative growth of 1.8%, which is a historical record.

“The deceleration in credit growth also highlights the role of supply side factors – stressed assets and capital constraint – in hindering a revival in the credit cycle. The sectoral data on flow of credit indicate that deceleration in credit, though broad-based, is characterised by a sharp contraction in exposure to industry”, the Ecoflash adds.

The banks are unwilling to lend anymore because of the mounting corporate debt.

The only solution is urgent cleaning up of the public sector banks: the twin balance sheet problems; mounting corporate debt; commercial banks’ piling up non-performing assets; the poor flow of bank credit and speeding up proposed bank mergers.

With the return of the 99% of the so-called black money, liquidity is no more a hurdle. RBI knows money stock has risen with unexpected deposits.

Monetary aggregates  (Rs billion)
Month/Year M1 M2 M3
January 2016 24,415.5 25,002.2 114,203.2
February 2016 25,255.5 25,862.1 115,608.9
March 2016 25,976.9 26,592.6 116,203.8
April 2016 26,713.0 27,360.0 118,860.5
May 2016 26,546.6 27,214.6 118,901.0
June 2016 26,695.7 27,303.5 119,571.6
July 2016 26,575.1 27,182.9 120,434.9
August 2016 26,914.9 27,522.7 121,102.6
September 2016 28,420.2 29,134.5 125,954.0
October 2016 27,685.2 28,399.4 124,150.9
November 2016 21,221.3 21,941.9 121,758.7
December 2016 20,004.6 20,725.2 120,506.5
January 2017 21,060.2 21,780.7 121,561.0
February 2017 22,590.3 23,310.9 123,082.8
March 2017 26,954.3 27,885.2 128,443.9
April 2017 26,094.9 27,025.8 127,261.4
May 2017 26,314.1 27,224.5 127,257.6
June 2017 27,100.1 28,010.5 128,117.0
July 2017 NA 27,846.5 128,807.8
August 2017 NA NA 129,968.9
Source: RBI Bulletin and Trading Economies

M3 has risen; RBI has to be on guard against inflationary conditions.

Instead of plodding the RBI for another cut in policy rate in the next October meeting of Monetary Policy Committee, the government should resume good governance.

It has to raise investor confidence.

It must bestow full autonomy on RBI in the pursuit of its mandated goal: price stability.

T.K. Jayaraman is a research professor under International Collaborative Partner programme at University of Tunku Abdul Rahman, Kampar, Perak, Malaysia. Bhanu Prakash is a Visiting Associate Professor, Bengaluru School of Management Studies, Bengaluru.

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