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Demonetisation will affect short-term economic growth, say economists

Nihar Gokhale | Updated on: 10 February 2017, 1:41 IST

The demonetisation of Rs 500 and Rs 1000 currency notes has brought the entire country to a standstill. While hundreds wait at the doors of banks and ATMs, those without bank accounts are suffering all the more.

These Rs 500 and Rs 1000 notes constituted nearly 86% of the country's legal tender. There isn't enough new currency, ATMs aren't calibrated for the Rs 2000 note, and banks are too short-staffed to handle the surge in customers.

The consequent cash crunch has hit the purchase of everyday needs, which is largely made in cash, as are most daily-wage payments.

Prime Minister Narendra Modi announced on Saturday that the situation will take another 50 days to return to normal. Not surprisingly, this has sparked concerns about how this will affect the economy.

Economists said that as consumption falls, economic growth would definitely be affected in the short-term. In the long run, while the informal sector would be badly affected, the rest of the economy's recovery depends on the amount of black money actually returning to the system.

Short-term shock

NR Bhanumurthy, Professor at the National Institute of Public Finance and Policy, said on the brighter side, in the short-term the cash crunch will have a "dampening impact" on inflation. (In economic theory, higher liquidity is associated with higher inflation levels, which is why the Reserve Bank of India wants to cut down lending to battle inflation).

But the lower inflation would perhaps not help economic growth, since the immediate impact of the cash crunch would be on all consumption-based sectors of the economy. This will reduce our consumption-dependent economic growth in the short-run, Bhanumurthy said.

The same view was echoed by Mausumi Das, associate professor at the Delhi School of Economics, who said there was a negative demand-shock across all income groups. While the liquidity crisis has hit the poor, even the upper classes have cut down on consumption due to a 'negative wealth effect'.

"Even the rich, who have access to cashless transactions, are also cutting down on consumption because they have a perception that they need to hold on to their money. The reduced consumption is visible in shopping malls," Das said, adding that this would be a temporary shock on consumption-related businesses, lasting three to five months.

"You can't just withdraw 85% of the currency without hurting the economy. Bulk of transactions, particularly in the unorganised sector, are in cash," said Prof Ravi Srivastava, former member of the National Commission for Enterprises in the Unorganised Sector.

Srivastava added that farmers would be significantly affected as this is sowing season, and they would need to purchase seeds, fertilisers, etc in cash.

"While the immediate impact may be for 50 days, bits of the economy will suffer much longer. These are sectors where a loss of income, such as this, can erode their ability to sustain their economy. The poor are bearing the biggest brunt - wage labourers, migrants, the unbanked. The impact on them is catastrophic," Srivastava said.

The long term

Bhanumurthy said that for the the medium and long-term, economic growth will depend on how much black money actually comes back into the system.

"We need to have a full understanding about how much money returns. Assume that 20% of the currency was in black money. If 10% of this does not come back, it will hurt the economy. But the other 10% that does return will possibly be invested into financial markets, which will have a multiplier effect on economic growth," Bhanumurthy explained.

The demonetisation will however have a permanent effect on the informal economy, according to former Chief Statistician of India Pronab Sen.

Writing in Ideas for India, Sen said that the informal sector includes many small-time capital lending funds like chit funds that although have some black money, are a lifeline for the poor.

"We might not shed any tears for them, but spare a thought for those whose livelihood depends on the capital provided by this sector because the formal financial sector will never touch them with a barge-pole. How large is this problem? I had made a rough estimation of this during the preparation of the 12th Five Year Plan, and it came to nearly 40% of formal bank lending - that is, 26% of GDP - which is not a joke," Sen wrote.

Ease them in

Manoj Pant, professor at Jawaharlal Nehru University, said that the government needs to make transactions easier.

"There are two kinds of demand for money - speculation and transaction. The government is going after the former but they need to do something about the latter. This should be either by permitting traders and farmers to conduct higher transactions at banks," Pant said.

"They should be worrying about transaction demands and not speculative demands, or else if this situation continues for another week then there would be serious trouble," he added.

Prof Pradeep Agrawal, RBI Chair Professor at Institute of Economic Growth (IEG), said that there could be unemployment in construction and luxury sectors, where demand would be badly hit.

However, this could be counterbalanced if the demonetisation is "handled intelligently and in good sincerity,"he said.

"Suppose around Rs 18 lakh crore is in black money, and even Rs 6-10 lakh crore returns to the system, the government can spend the money on building infrastructure, as well as on welfare measures such as job guarantee, food security, education, healthcare etc. These will also give employment. Inflation would reduce in the short term, and RBI could reduce interest rates. But the effects would take a year to come into effect. The benefits from demonetisation would come slower, but the harm is faster," he said.

First published: 14 November 2016, 4:12 IST
Nihar Gokhale @nihargokhale

Nihar is a reporter with Catch, writing about the environment, water, and other public policy matters. He wrote about stock markets for a business daily before pursuing an interdisciplinary Master's degree in environmental and ecological economics. He likes listening to classical, folk and jazz music and dreams of learning to play the saxophone.