The announcement that currency notes of Rs 500 and Rs 1,000 denomination would no longer be legal tender brings down the currency in circulation by 85 per cent. It now appears that it would take several weeks to replace the Rs 15 trillion of currency demonetised. In assessing the impact of this development on the economy and the markets, we are in uncharted territory. At least in recent memory, there seems to be no precedent globally of a country attempting this. In the often cited 1978 episode in India, the demonetised notes were just 1.6 per cent of currency in circulation by value, and therefore not as significant for the broader economy.
The potential impact gets amplified by the Indian economy’s high cash dependence. Currency in circulation is 14 per cent of the GDP, whereas in most other large economies it is less than five per cent of the GDP. This is closely linked to high informality. More than 90 per cent of India’s workforce works without a job contract, and 45 per cent of India’s output is informal. Not all of this is “black” in the sense of tax evasion. Examples range from small farmers selling milk to small truck operators, kirana stores and road-side dhabas. Further, even for the formal sector, last-mile distribution for most supply chains involves a cash interface. More than 90 per cent of all purchases in India occur through cash.
In the near term, many of these transactions have frozen due to lack of currency availability. Earlier a truck operator would hand over currency to the driver to fill up diesel en-route (nearly 80 per cent of transactions at fuel pumps are in cash) and to pay toll. In the absence of hard currency, that is no longer possible. Or take a dairy farmer selling 50 litres of milk every day — how does he get paid his Rs 1,500 at the milk-chilling centre? But for most supply chains, the disruption would last only slightly longer than the time taken to normalise currency availability.
The risk is, for some small businesses, like producers of perishables (for example milk or vegetables), even a short-term disruption may push them back by several months if not a year, given that they have very small savings buffers. Disruptions in harvesting of the kharif crop and sowing of the rabi crop could also hurt. Microfinance (MFI) and Non-Banking Finance Companies (NBFCs) that lend to these businesses and also primarily deal in cash for last mile collections could see delays in repayments and even defaults, perhaps necessitating some regulatory forbearance to prevent the damage from intensifying. Some have already declared moratoriums on repayments.
That is not to say all transactions have frozen. Where both parties are well known to each other (for instance, a milk seller and a householder), once the initial shock of a lack of currency has worn off, innovations are likely, like credit temporarily replacing cash. Humans have been known to be very creative with abstract notions like money.
In any case, a positive side-effect of this short-term pain should be an incentive to transition to electronic payments and cashless systems. Rising demand for debit/credit card readers is an encouraging sign. Interestingly enough, even as the cash economy suffers from a lack of “liquidity”, the formal banking system is seeing a flood of deposits (Rs 3 trillion in the first five days). There are already expectations building up of deposit rate cuts and Indian bond yields have declined meaningfully despite the rise in global yields.
The longer lasting damage would be for the black economy. Cash that cannot be laundered in the next 50 days becomes worthless. If one assumes this is 20 per cent of the Rs 15 trillion, nearly Rs 3 trillion of wealth gets destroyed. It may be a fraction of the total “black” wealth, but is still a substantial amount. Further, it would be wrong to assume this was cash under the mattress, that is, was not used for transactions. While currency for the “white” economy may get replenished in two months, that for the “black” economy may take years to regenerate, slowing down the black economy significantly. A switch to gold is possible, but given its price volatility, it is not as easy an alternative.
This is likely to affect demand in categories that have high-value transactions like houses, land and jewelry, and thus have some lasting impact on the formal economy as well. Land transactions, in particular, could get affected, as these are usually between farmers, and agriculture is primarily cash-dependent. Weaker real-estate prices could also pressure loan recoveries at banks and NBFCs that have exposure to real-estate developers and have loans against property (LAP).
It would be unwise to declare victory too soon. The next month and a half would see a cat and mouse game between the government and the tax evaders. Take for example private security guards normally paid by cheque getting cash this month (you guessed it, in Rs 500/Rs 1,000 notes). As there are six million guards in India, this adds up to a large number. Evaders would find creative ways of laundering cash and the government of stamping down on them.
There are likely to be fiscal implications too. Economic disruption could hurt the tax take, even if temporarily, but more cash coming into the banking system could mean higher disclosure of income for this year as well, even if only the explicable part of the income is deposited. There is another issue. The currency in circulation is also a liability of the RBI and is zero-cost debt for the government. The currency notes that get cancelled would get accounted as gains for the RBI. Some have extrapolated this to mean a big fiscal boost for the government, but that appears unlikely.
Few would deny the medium-term benefits of this radical move. If successful, it can catapult India from the low equilibrium of low taxes/small government to a higher equilibrium seen in more developed economies. But the associated disruption can be painful in the interim and the uncertainty would test the patience of many an observer. This is more so as, combined with the economic disruption likely when GST starts next year, disorienting changes in the economy could last nearly a year and a half. There had been a clamour for radical reforms. This is what real reforms feel like: They involve risk, and some disorder.