Demonetization 24122016 atl

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Information about Demonetization 24122016 atl

Published on December 27, 2016

Author: prasalfinancialadvisory


1. DEMONETIZATION An overview and consequences On November 8th 2016 at 8 PM, Hon’ble Prime Minister Shri Narendra Modi addressed to the nation on television and announced that all the currency in circulation valuing Rs. 500 & Rs. 1000 will not remain valid legal tender from midnight. The intention of the government behind this move was to curb black money, restrict the terror funding, to tackle with counterfeit currency. All of this, the issues which create a tragic environment in the state such as parallel black economy, internal as well as external security of the nation and loss to the masses respectively, and hence we all should support the intention of the government. The policy which was adopted by government to tackle the issues discussed above is called ‘Demonetization’. It means the high denomination value currencies are replaced by newer range of currency or possibly with lower denomination currency. ‘Demonetization’ is an economic measure which is not adopted by any developed nation except United States of America (approx. 124 years ago). Why do nations do not adopt this measure? I will try to attempt and resolve this question in the next paragraphs of the article. Now hereby I will try to explain each and every aspect and consequences of this move on economics. 1. Government’s view and thought Apart from the above, another reason behind this measure was to phase out all the counterfeit and black currency from circulation which would be beneficial for the government. As per the estimation and various reports of the Finance Ministry of Government of India, the total value of the high denomination currency was 86.4% (approx) valuing to Rs. 14,000 crore before demonetization. The Government was of the view that out of Rs. 14000 crore only Rs. 7000 to 8000 crore will come back into the banking channel and therefore Rs. 6000 crore would be the benefit of the government which was to be paid by the Reserve Bank of India to the government over the years. After this decision, Government was of the view that the GDP of the nation would also increase by at least 1.5%. Reason behind this view is quite simple which is explained as follow. “Since money is not added to the GDP as GDP refers to total goods and services produced or provided during the fiscal year, but government will get part of money (unaccounted) from RBI over the years which would not get deposited or not come into banking channel due to demonetization. Such money will not be considered as the borrowing and hence government is not required to pay any interest on that money and hence can spend it on infrastructure and other public expenditure which will ultimately get added to the GDP and hence GDP would increase”. Another aspect of this decision was to promote digital payments and receipts and to create a cashless economy to the extent possible. This is a good step and we all should appreciate this but at the same time we should also consider that no economy can be cashless completely.

2. Sweden ranked first as lowest cash to GDP ratio in the world while at the end of March 2016 India’s cash to GDP ratio was 10.6% which is highest among BRICS and it is also one of the highest in the world. Cashless economy has its own benefit such as tracking of all transactions; more and more people will come within tax regimes which will ultimately result into better tax administration, low tax evasion and hence higher revenue to the government. It sounds good that one day we would also live in cashless economy. The Government also opined that the funds which will get deposited in the bank could be provided as loan to the industrialist and manufacturer so that investment can be increased and hence growth can be boosted. 2. Practicality The rationale behind the thought that “All Black Money is in Cash and All Cash is Black Money” can’t be justified on any ground. Cash portion is only a fraction of Black Money. We have popular saying in economics that ‘Black Money has its own leg and it finds ways to defend itself’. The same applies to the present case. Till date total Rs.12,000 crore (approx.) came in to the banking channel and the prediction of government failed. Also an economic or basic educated mind will never keep black money in cash as it’s a basic principle of economics that the purchasing power of idle cash declines day by day and hence people invest their income portion which is black into working capital, real estate, gold and other securities. The rationale of the government to provide more and more financial assistance to the manufacturer and industrialist is also not understandable. Since the deposited money does not constitute part of capital to the bank, banks would not be able to release these funds as loan though the government has restricted the withdrawals. In addition to this point Reserve Bank of India has surprised everyone by keeping the rate stagnant while everyone was expecting a rate cut of 0.50 % bps. In my view, RBI is aware of the fact that the all deposited money can’t be released. In addition to this point, the NPA situation of the Public Sector Bank is also not good and it has increased drastically in second quarter of the year. New Bankruptcy code will help us to clear out this position to the extent possible and we all must appreciate this. One possible thing which I found as reason for not changing the rates by RBI is non- availability of accurate data from rural part of the nation. The statements and ideas of the government which it intends to implement remind me of Voodoo economics (also known as Regonomics). This pattern of economics was followed by US President Mr. Ronald Regon in whereby he lowered the tax rate, increased money supply to rich people and industrialist as he was of the view that if we provide more money in the hands of companies and industrialist, they will invest such excess money in production activity which will help in creating job opportunities and increased productivity. Though it helped the USA to come out from heavy unemployment, to increase productivity and consumption of people but it also had its own demerit such as higher inflation, increased wealth gap, etc. which was one of the possible reasons behind the recession of 1991-92 in USA. I am not much sure and I also would not reach to the conclusion but just want to raise one point. In the first quarter of the fiscal year, WPI inflation rate was -5% as compared to CPI rate +5%. WPI basket consist more of the manufacturing machines and goods which are not in nature of consumer goods as compared to the composition of CPI. Deflation in the WPI clearly shows that no manufacturer or industrialist is ready to invest in area which helps us to produce the consumer goods rather they would also keep demanding for consumer goods and hence we have positive CPI of 5%.

3. Here multiplier theory (proponed by J.M.Keynes) does not work which suggest that the consumption of household will be used by Firms for producing the goods and they will invest it in infrastructure and manufacturing area. Today inflation is low but we must remember that it has been created and not natural. Why am I saying it has been created? Since the government has restricted the money supply in the market, households do not have money to spend and all together has resulted in lower demand. My utmost concern is the sphere of rural economics. It has collapsed due to this decision as the old currency is not in circulation and also not accepted and new currency is also not delivered till now. Rural demand is lowest and also all the economic activities have come to a halt due to insufficient supply of currency. I would also emphasize on one point since no one is talking about it. Banks are lowering their interest rates on deposit and they have their own valid reason. Since their deposits have increased drastically and they have to pay interest on such deposits, but in order to reduce their liability towards interest payment they are lowering the rates. My concern is not declining interest rate but people’s trust and their economic behavior. Once they will realize that the banks are not paying such rate of interest which they want they will not keep their money in the banks rather they would provide it directly to the other person on higher interest rates which would ultimately create more and more money-lenders and hundis system in the market. And last but not least the intention of the government is good but the method adopted is not. 3. Views There are so many views of noted economists and various analysts which help us to understand demonetization post which I will also express my opinion on the same. Dr. Amartya Sen (Nobel Laureate) Dr.Sen termed it as a “despotic action that has struck at the root of economy based on trust.” “It’s (demonetization) a disaster on economy of trust. In the last 20 years, the country has been growing very fast. But it is all based on acceptance of each other’s word. By taking despotic action and saying we had promised but won’t fulfill our promise, you hit at the root of this.” Dr. Manmohan Singh (Former Prime Minister, Finance Minister, Reserve Bank Governor & Economist) Dr. Singh stated that the intentions of the government can’t be questioned and we should all support the same but the method adopted for fulfilling the said intentions is not quite good enough and termed it as a monumental mismanagement. He also stated that no nations in the world where people who have deposited their money into the bank are not able to withdraw it. He also emphasizes on the consequences of the same on the SME and domestic industries which are relatively small since their business was carried out in cash. As the government stating its benefit in the long run, Dr. Singh has raised a very good question and I do agree with the same that can we quantify that long term for which we are paying? Here I want to quote J M Keynes “In the long run, we are all dead”. Although the intention of the government was good enough but here again I quote Dr. Singh “Road to the hell are paved with good intentions”. He also estimated that the total GDP will decline by 2% (annual basis). Dr. Raghuram Rajan (Former Reserve Bank Governor and Economist) Dr. Rajan was the governor of Reserve Bank of India from September 2013 to September 2016. Same proposal was put before him during his term of office but he denied the implementation of the same stating that it cannot be considered as the best measure to curb out black money and another issues.

4. He also said that the people who have black money will find another ways to defeat the move and also will succeed in converting their black money into white without paying any tax. Today most of the people are doing the same and at the same time government and revenue officials are not able to track all the transactions. Dr. Rajan is the governor who pioneered the payment bank system and we cannot ignore his tremendous contribution towards economy and its digitalization. He had emphasized on better tax administration to curb out black money rather that demonetization. S. Gurumurthy (Chartered Accountant and Columnist) Mr. Gurumurthyhas opined various positive points such as reduction in cash hoarding, unorganized economy will get organized, real estate prices will go down along with gold, lower interest rate so that people can take loan. All of these arguments are in favor of supply side and it reminds me more of Voodoo Economics. Though interest rate will decline in future but banks and other lending agencies are not ready to sanction the loan as they consider the risk factor. Bibek Debroy (NITI Aayog Member, Government of India and Economist) Mr. Debroy has suggested and strongly feels that the GDP will rise rapidly after this move. He has also made his point on the view that the economy will not get affected in short run due to this move. I do not agree with him as he said that the economy will not decline. I have an argument on this point that how economy will not decline? We don’t have cash in the system to pay wages to daily wage earner causing decline in productivity, lower domestic demand due to cash crunch, rural economic activities have stopped due to inadequate supply of currency, people are wasting their productive time in queues which can be rather utilized productively which would ultimately raise the problem of economic slowdown. Apart from above there are many more views from the globe and most of them are not in support of demonetization. Moving towards the cash less economy and digitalization is very good and appreciable step but before this government should create an awareness about this concept, network building, security of money and data, infrastructural facilities etc. Adopting this move has its own cost such as printing cost of currency, implementation issues, and administrative problems and if we sum up all the losses which we have incurred in terms of waiting in queues, extra work done by staff and other relative and opportunity costs then it will exceed the benefit of demonetization. Autonomy of Reserve Bank is also in question which I will try to explain later. Finally we can hope for better future and expect that the inconvenience to the people will come to an end as soon as possible. You can reach me at for more discussion. Atulkumar Singh Sr. Analyst Economic aspect of Demonetization Disclaimer: The views expressed or implied in the article are that of the author and may not necessarily represent the views of PRASAL.

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