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Why low inflation after demonetisation is bad news for India's economy

Abhishek Parashar | Updated on: 14 December 2016, 19:10 IST

The first glimpse of the fallout of demonetisation on Indian economy is out in the open. The retail inflation has fallen to a two-year low of 3.63% in November. However, it is a cosmetic change driven by the sharp decline in demand following the demonetisation of Rs 500 and Rs 1,000 notes from 8 November.

The ongoing cash crunch has taken its toll on small-scale industries, markets, unorganised sectors and small companies across the country. It has severely affected the income as well as the spending of the common man. This depression is reflected in the figures of the retail inflation that are lower than even the Reserve Bank of India (RBI) estimates.

The central bank has set a retail inflation target of 4% for the first fiscal quarter of 2017. With retail inflation hitting below this level and nearly Rs 12.50 lakh deposited in banks since 8 November, the RBI could consider cutting interest rates during its next review meeting. The market and industries have already started hoping for this decision.

However, one must keep in mind that the retail inflation has not come down due to a natural decrease in demand or an improvement on the supply side. This is only because the buyers lack cash despite their money lying in bank accounts.

A recent study by citizens connect platform Local Circles has confirmed the decline in income and spending after the note ban. The majority of 15,000 people surveyed across 220 districts for the study accepted that their purchasing power has considerably reduced despite money deposits in banks.

Rating agencies like Morgan Stanley, Bank of America Merrill Lynch and Finch Financial Services have slashed their forecasts for India's GDP growth for the current financial year. The former two have cut down their estimates from 7.7% to 7.4%.

Similarly, Finch Financial Services has revised its projected figure of India's GDP growth from 7.4% to 6.9%. The RBI has also decreased its GDP growth rate projection for the current year from 7.6% to 7.1%.

Perils for rural economy

The rural economy has been the worst sufferer of demonetisation. The downward trend in the sale of two-wheeler vehicles during November has highlighted this fact. The Local Circles survey suggests some states have been more severely affected than others.

The fall in income in states such as Bihar, Jharkhand and Odisha is more than states like Gujarat, Maharashtra, Madhya Pradesh, Uttar Pradesh, Delhi, West Bengal and Kerala. In contrast, spending has come down considerably in Maharashtra, Rajasthan, UP and Punjab.

There is no doubt that black money is among the prominent factors for high inflation. But, it is only one of the reasons. The total black money in terms of currency is only around 6% of the total illicit money. The amount of old currency notes deposited so far clearly suggests that the aim of delegitimising this 6% of currency has not been fulfilled.

The State Bank of India's (SBI) report had predicted around Rs 2.5 lakh crore will not come bank to the banking system. However, an estimated amount of Rs 12.50 lakh crore had been deposited in banks till 10 December.

The SBI has pegged the total value of old Rs 500 and Rs 1000 notes at Rs 14.18 lakh crore. This excludes the money already lying in bank accounts. There are still over two weeks left for depositing the delegitimised notes.

Market slump

Demonetisation has directly hit the consumer market. Most buyers are facing the cash crunch, thereby reducing their purchasing capacity. This is the main reason for fall in retail inflation.

The good monsoon this year had raised the expectation of improved supplies after two years of drought. But, farmers are facing difficulties in buying seeds and fertilisers after 8 November. Even the RBI has expressed doubts over the yield of winter crops due to the note ban. The long queues outside ATMs and banks are reducing the productivity of urban workers.

A better monsoon would have balanced the gap between demand and supply under normal circumstances. This would also have increased demand in rural areas, thus benefitting the economy.

However, demonetisation has weakened these prospects. Especially, under circumstances where India's growth rate was being considered vital for the economic condition of the entire Asia-Pacific region.

First published: 14 December 2016, 19:10 IST
Abhishek Parashar @abhishekiimc

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