The government’s bold decision to demonetise Rs 500 and Rs 1,000 notes to curb black money has set in motion a tectonic shift. The move, in a single stroke, aims to annihilate the omnipresent shadow economy, while paving the way for safer and superior “cash-less” way of transacting. The prelude to the announcement can be traced to a series of complementing stepping stones laid out systematically over the last 2.5 years by the government in the form of the Jan Dhan Yojana, DTAA amendment with Mauritius and Cyprus and the most recent Income Disclosure Scheme.
From an impact perspective, there is no doubt that the process of “demonetisation to remonetisation” would involve some short-term pain as economic agents struggle to cope with the sudden liquidity shortage. Some sectors will face deeper challenges, but these should be viewed as teething troubles. The multitude of benefits I expect the economy to accrue in the medium-to-long term, will far outweigh the near term consequences of the demonetisation drive. As such, I expect the Indian economy to follow a “tick-mark” shaped recovery over FY17-18 characterised by a 1-2 quarter slowdown, followed by the attainment of an inflection point or local minima, to be chased by exponential growth in quick succession.
The first long-term gain will be a swelling of the deposit and savings base. Global agencies have pegged the size of the parallel economy in India at close to 23 per cent as of 2007. Unaccounted cash in the economy is estimated to at Rs 4,500 billion of which a certain proportion will make its way to the banks. Banks’ deposit base will receive a fillip of 0.5-1.4 per cent of the GDP. Savings will rise by a similar proportion, due to a switch from unproductive physical assets to financial assets.
Second, there will be an improvement in monetary transmission accompanied by reduced lending rates. A rise in the deposit base will allow banks to lower the blended cost of funds as higher CASA deposits help to replace the high cost of borrowing and lower the overall cost of funds. I expect banks to reduce deposit rates by 75-100 bps over the next six months. The new regime of MCLR will immediately take into account the lower cost and will thereby lead to a decline in lending rates, which will boost economic activity in the medium term.
The demonetisation move will also provide a fillip to Jan Dhan accounts and financial inclusion. Over the last two years, while the number of Jan Dhan accounts has recorded a stellar growth, the share of these accounts in the total deposit base of the banking system has remained under one per cent. The demonetisation drive should give a push to cash deposits in Jan Dhan accounts, of which close to 43 per cent have remained dormant. In addition, the move will help to inculcate banking habits among the large unbanked population.
Finally, with some part of unaccounted money making its way into the formal channel the government stands to benefit from higher income tax collections. This should help cushion the government’s FY17 fiscal deficit target, especially post the shortfall in anticipated spectrum revenues. Demonetisation will move the economy from the unorganised to organised sector, dovetailing into GST architecture that is expected to come on board next year. This will stand to enhance the government’s ability to tax commercial transactions.
With 85.2 per cent of the currency in circulation as Rs 500 and Rs 1,000 notes ceasing to be a legal tender, currency for transactional purpose has plunged in the economy. Some of the sectors are which are cash-intensive — such as real estate, retail trade, gold, hotels, transport and communication — are likely to witness short-term disruptions. In addition, the demand for both consumer durables and non-durables will see a pullback owing to liquidity constraints. Cumulatively, GDP growth for FY17 could see a downside to the tune of 40-50 bps. Having said so, I believe that in the process of building long-term benefits, the economy will have to endure a few near term pain points. In fact, demonetisation offers a unique opportunity to reform the way business is done in India in many sectors. For instance, microfinance institutions that have been struggling to inculcate the habit of cashless transactions could well use this window to hasten the move towards electronic mode. Likewise, banks and business correspondents in rural areas could encourage opening of fresh accounts under the Jan Dhan to further financial inclusion.
Taking forward the words of outgoing US President Barack Obama that “change is never easy, but always possible”, I believe that change can be made easier, if we all strive towards it. In this context, government’s efforts over the last one week to continuously assess the progress of implementation and announce incremental measures to ease the operational burden on citizens is heartening. Importantly, the role being played by my banker colleagues also deserves a special mention, for the national service they are rendering to actualise the government’s vision.
As responsible economic stakeholders, we must prepare ourselves to endure the short-term pain, for long run positive externalities of demonetisation. The positive spillovers for growth will be immense, with a sustainable 8 per cent GDP growth now seeming more of a reality than an aspiration.