Will demonetization adversely impact GDP growth?3 min read . Updated: 10 Nov 2016, 09:13 AM IST
Some economists say demonetization will adversely impact India's economic growth even as others believe the disruption is unlikely to be significant
New Delhi: The government’s move to suck out 86% value of money in circulation by demonetizing ₹ 500 and ₹ 1,000 currency notes will adversely impact India’s economic growth, at least in the short run, fear some economists. Some others, however, maintain that the demonetization move, taken to weed out black money and counterfeit notes in circulation, will have little effect on the economy.
Former chief statistician of India Pronab Sen said with 86% of value of money in circulation, the economy will have to make do with only 14% of money in circulation at least for two weeks, until when there are restrictions on withdrawing money.
The government has announced that withdrawal through ATMs will be limited to ₹ 2,000 per day up to 18 November and ₹ 4,000 per day thereafter. Cash withdrawal from one’s bank account is also limited to ₹ 10,000 per day and ₹ 20,000 per week till 24 November.
Sen said this will impact a large number of cash transactions which will have a multiplier effect on the economy. “If I am not going to able to sell, I am not going to buy from my supplier which will kickstart a chain reaction. So even if the first round impact of lower money circulation may not have a large impact, the chain effect will be large," he added.
Sen said it is the informal sector accounting for around 40% of the economy which will be impacted the most, especially in rural India. “This is likely to reduce GDP growth by one percentage point this year (2016-17)," Sen warned.
GDP growth in the first quarter (April-June) slowed down to 7.1% from 7.5% during the same quarter a year ago and the slowdown is attributed to increase in subsidy payments by 53% which resulted in lower growth in indirect taxes. The government expects the GDP to grow at 8% in 2016-17 on the back of a bumper farm production due to normal monsoon.
Sen said the situation could have been better handled by giving a longer period of time to phase out high-value currency notes instead of making them invalid overnight. “The impact in rural India will be much more due to the sheer logistical difficulty for banks to reach out to depositors. It will also impact urban poor who depend on daily wages," he added.
N.R. Bhanumurthy, professor at the National Institute of Public Finance and Policy, said a decline in money supply will directly impact growth in the short run using the quantity theory of money.“If all the money sucked out of the economy does not come back which is likely due to the existence of black money, then it will directly impact growth in the short run. The extent of its impact on growth will depend on the size of unaccounted money in the economy," he added.
Current chief statistician of India T.C.A. Ananth, however, said the disruption due to demonetization in the economy is unlikely to be significant. “The rural economy has changed a lot compared to what it is used to be 30-40 years ago. It is only a transitory phenomenon of shifting from one currency to the other and is unlikely to have any significant impact on the economy," he added.
Finance minister Arun Jaitley, responding to a question at a press conference on Wednesday, ruled out any short-term impact of demonetization on growth, holding that it will rather benefit growth in the long run because “all this will impact the size of the GDP itself because more transaction that were happening outside the (formal) economy will get into the economy itself".
However, both Sen and Bhanumurthy said demonetization will bring down inflation in the economy, though for different reasons.
Sen said lower money supply will lead to a deflationary situation with too little money chasing too many goods. Bhanumurthy, on the other hand, said demonetization will play a positive role in curbing inflation in the medium term due to lower money supply as unaccounted money used in sectors like real estate and higher education will be taken out of the system.