Economic Impact of demonetizing high value currency notes

Categories: Blog
November 10, 2016Posted By Admin

Indian economic vehicle is mostly dependent on cash based transactions which has several negative impacts. The primary one is the black money which is unaccounted and used to evade taxes and scrutiny. Second one is high value fake notes which looks like same currency notes have become widely circulated and used for illegal activities. And also high circulation of cash in the economy will ease the access to fund terrorism, smuggling and other dangerous activities.

From the time it came to power in 2014, the central government has taken several steps to bring black money out of its roots, but nothing has fructified. Recently government allowed people with unaccounted money to disclose these funds under the recently concluded Income Disclosure Scheme. While announcing the decision on Tuesday, Prime Minister Narendra Modi, made it clear that the government wants to clamp down on the black economy by taking high value Rs 500 and Rs 1000 notes out of circulation. This strong decision will stand as one of the boldest and major step in Indian economic history.

The magnitude of cash in circulation is directly linked to the level of corruption. Inflation becomes worse through the deployment of cash earned in corrupt ways. The poor have to bear the brunt of this. It has a direct effect on the purchasing power of the poor and the middle class…High circulation of cash also strengthens the hawala trade which is directly connected to black money and illegal trade in weapons…To break the grip of corruption and black money, we have decided that the five hundred rupee and thousand rupee currency notes presently in use will no longer be legal tender from midnight tonight, that is 8th November 2016. -Narendra Modi, Prime Minister of India


India is among the highest cash usage countries. The above picture depicts that the amount of consumer transactions carried out in cash in different countries. In India 98% of the transactions happens through cash in volume terms while it is at 68% in value terms.  Reserve Bank of India (RBI) data suggests that the proportion of Rs.500 and Rs.1000 notes were 86.4% of total value of notes in circulation on March 31, 2016, amounting to Rs 14 trillion.

According to McKinsey, the shadow money (means which is not included in GDP) in India is around 26% of GDP. Which means one fourth of the money in India goes un accounted and acts as hinder to the growth of the economy. If not solved this is also increases the risk of income inequality which is big negative for developing countries like India.

What happens to the country without cash?

Money is like fuel for any economic vehicle in which cash is one type of fuel. The cash as fuel is not good for economies as it has many negative impacts as explained above. In an effort to transition to the efficient mode and to remove the bad fuel (black money), Economic vehicle will get slow down (GDP growth) when almost entire fuel (86% of cash value) is replaced at one time. Though this will have a great advantage over the long term, economic growth will get impacted in the short term to medium term. And this duration depends on how fast and how smoothly it is being replaced.

What kind of impacts we will have in near future:

With most of the unaccounted money comes in to the system, the tax revenue of the government will witness sharp growth. As it becomes difficult to unorganized players to channelize funds for their daily business needs, many will move out of the business and with limited tax arbitrage between organized and unorganized segments, India will see much sharper move from unorganized to organized segment. Good for listed organized players in different sectors.

We will have immediate impact on consumer discretionary spending as most of them purchases through cash mode. They will post pone their decisions to purchase discretionary items mainly high value items. This will also act as catalyst to push consumers towards alternative sources such as digital payments.

When the consumption stalls, the demand for goods will decrease and there by reduction in prices. The reduction in prices will lead to lower inflation which will give more room for interest rate reductions. The value of rupee will strengthen slowly as time passes.

The operations of the small scale industries will get hit as most of them use cash as working capital. They now have to reschedule the payment cycle. Until they find alternate mediums it will be difficult for them to operate regular business transactions.

The highly cash dependent sectors like Real Estate and Gold where most of the black money lies will have lager impact. As the real estate sector already reeling under pressure this will create further problems to unorganized players. We will see low growth or no growth in new apartment sales and will also see correction in land prices across all major markets

Banks will get benefited more as every existing currency notes of Rs.500 and Rs.1000 has to go to them. Bank deposit growth will witness a pickup and currency in circulation will moderate – a positive for banking sector liquidity.  The deposits will increase the CASA ratio of banks and they will also get access to funds at cheap cost which have positive impact on banks profitability.

This move will also impact and lower the political spending during elections especially in states like Punjab and UP where huge cash is spent during elections.