The Deep Shock of Demonetisation May Devastate the Economy

An equity firm has estimated that GDP growth will crash to 0.5% in the second half of the current financial year.

The Reserve Bank of India headquarters in Delhi. Credit: Reuters/Files

The Reserve Bank of India headquarters in Delhi. Credit: Reuters/Files

Even the supporters of Prime Minister Narendra Modi’s demonetisation plan agree that the economy will suffer in the immediate months after the long drawn replacement of 86% of all currency with the public is concluded.

Various industry experts and equity analysts, who generally back Modi’s policies, have said businesses will be severely impacted in the short run. The business TV channels are busy estimating the damage in the next six months as cash dries up across industry segments, especially in the small and medium sector. There is talk among the manufacturers of two wheelers, sold mostly in rural areas, that they will soon scale down production and reduce the number of work shifts for some months at least. The construction sector is expected to be hit the worst and this will impact the sale of construction materials such as cement and steel. Trade and manufacturing bodies have reported an over 50% drop in economic activity due to the monetary shock.

Rural wage growth was already down to zero and the current monetary shock will lead to further shrinkage in rural incomes and is bound to result in more joblessness. The rabi sowing season is in chaos as farmers are lining before banks for cash to buy seeds, fertilisers and other materials, and have already lost half of the 20-day window available for sowing. They say productivity of the rabi crops will be much lower this time. This could cause both a demand and supply shock in the medium term.

Ambit Capital, a respected Mumbai-based equity research firm, has officially estimated that the demonetisation-driven cash crunch will result in GDP growth crashing to 0.5% in the second half of financial year 2016-17. This means the GDP growth for six months, from October 2016 to March 2017, could decelerate to 0.5%, down from 6.4% in the previous six months.

Further, Ambit Capital estimates that during the October to December quarter that we are currently in, the GDP growth may contract, thus showing negative growth. However, Ambit is hopeful that a strong formalisation of the informal economy will ensue through 2017 until 2019 and this disruption could also crimp GDP growth in 2017-18 to 5.8 % from their earlier estimate of 7.3%.

There are other equity research firms who also feel the economy will sharply slow down for six months, but have yet to hazard an estimate like Ambit Capital has done. What seems clear is that there will be large scale destruction of the cash-based economic activity in the medium term. The government will have to counter this with a series of new policy initiatives which can come in the Union budget or even before that. The scale of economic destruction will also depend upon how quickly the government and RBI manage to replace the currency worth Rs 14 lakh crore.

Former RBI governor Y. Venugopal Reddy, known for his sharp instincts as central banker during the 2008 global financial meltdown, has interesting advice to offer the government. He told The Wire that this scale of currency replacement is highly risky and disruptive, and it depends on how the government and RBI manage the situation from here. Reddy says the most critical challenge for the government will be to ensure that the working capital of small businesses is replenished by the banking system. “About 30% of the working capital of small and medium businesses comes from the black segment of the economy. When you pull out money of this magnitude you will have to replenish it with fresh credit,” says Reddy. This could mean banks delivering anything between Rs 4 to 5 lakh crore of fresh working capital to micro, small and medium businesses so that their production cycles are resumed. These sectors contribute to 40% of India’s GDP and over 75% of employment.

The informal and formal economies don’t exist in separate silos and are joined together in a common value chain. The Indian economy is like a big whale which has large black and white patches over its body. But it is one integrated organism. It is this complexity that the policy makers in the government will have to internalise, before coming up with follow-up policy measures. The follow-up policy measures are very critical without which demonetisation alone will not work. Economist Surjit Bhalla, who has backed Modi’s economic policies, has also said without the follow-up structural measures, including the election funding reforms, all that the current demonetisation will achieve is one big black hole.

After the painful currency replacement, which some say could last three months, what we will have is an economy whose growth rate would have shrunk to near zero. It will be like a patient in critical condition. The government may have the bonanza of Rs 2.5 to Rs.3 lakh crores as currency which gets extinguished as the owners do not come forward to replace it. This will show up as increased net worth or reserves of the RBI. The RBI may lend part of this to the government, without impacting inflation, for enhanced spending on physical and social infrastructure. These are possibilities in the longer time frame.

There is no doubt that the economy, especially the informal sector and agriculture, will have to recover from a deep shock.

The famous economist John Maynard Keynes had said in the long run we are all dead. The nature of the current demonetisation, such as it is, may even kill us in the medium term!