Demonetisation: How long will the effects of Modi’s shock therapy linger?12 min read . Updated: 06 Jan 2017, 01:21 AM IST
MintAsia takes stock of the 50-day demonetisation exercise and analyses what lies ahead
MintAsia takes stock of the 50-day demonetisation exercise and analyses what lies ahead
New Delhi: In a New Year’s eve message to the nation, Prime Minister Narendra Modi described the 8 November demonetization of high-denomination currency notes as a cleansing ritual.
“Our nation has been witness to a historic rite of purification," Modi said in his televised address. “The patience, discipline and resolve displayed by 1.25 billion Indians will play a critical role in shaping the future of the nation for years to come."
Modi, 66, returned to a theme he stressed when, with shocking suddenness, he scrapped Rs1,000 and Rs500 banknotes: this was war against corruption and the shadow economy, counterfeiting of currency and terror financing.
Somewhere along the way, as Indians reeled under an unprecedented cash crunch, the government had spun the exercise as an attempt to convert the nation into a cashless economy.
The 50-day exercise, which ended on 30 December—the last date for the deposit of old currency notes—has taken its toll on the economy, especially the informal sector. And although the serpentine queues outside bank branches and automated teller machines (ATMs) that formed in the immediate aftermath of demonetization, for both deposit and withdrawal of money, have dwindled, it’s clear the pain won’t end anytime soon.
In one fell swoop, by invalidating Rs1,000 and Rs500 notes, the government took out of the economy Rs15.4 trillion of cash—86% of the value of currency in circulation.
By 10 December, the Reserve Bank of India (RBI) said Rs12.44 trillion in demonetized notes had been deposited in bank accounts—a figure disputed by the finance ministry, which cited the possibility of double counting.
The finance ministry said half the currency that had been taken out of the system would be back in circulation in the form of newly printed Rs2,000, Rs500 and other low-denomination notes by 31 December.
Neither RBI nor the finance ministry had (as of the time this edition went to the press) has updated figures for the amount of deposits and the amount of new cash injected into the economy, making a short-term cost-benefit analysis of demonetization difficult.
On 29 December, finance minister Arun Jaitley decried critics of demonetization by citing impressive revenue gains. Indirect tax collections shot up in April-November by 26.2% while net direct tax collections rose 13.6% till in the financial year until 19 December.
“Assessment (by critics) could be unreal. But revenue figures are real," Jaitley said.
Analysts are unimpressed with the claim.
Ranen Banerjee, partner and leader of public finance at PricewaterhouseCoopers India, said the effect of demonetization will be more on the informal economy, which is cash-based, than the formal economy.
The informal economy comprises small manufacturing units, street vendors and mom-and-pop stores, that are neither taxed nor monitored by government.
“So far, we have data only pertaining to the formal economy, which will feel the impact with a time lag. We need to wait and watch for the fourth quarter (January-March) GDP (gross domestic product) numbers to assess the full impact of demonetization," Banerjee said.
Some data is indeed available and it shows the damage done by the exercise. Data with the Centre for Monitoring Indian Economy (CMIE) shows announcement of new investment projects fell sharply.
New investment proposals worth Rs1.25 trillion were made in the quarter to December 2016 (October-December), compared with the average Rs2.36 trillion worth of new investments in the preceding nine quarters of the Modi government.
CMIE said data suggests demonetization has hit the pace of announcement of new investment proposals. It said 227 new investment proposals worth Rs81,800 crore had been announced in the quarter until 8 November. In comparison, only 177 investment proposals worth Rs43,700 crore were made between 9 November and 31 December, it said.
New investments worth Rs2,097 crore were announced, on average, per day during the 39 pre-demonetization days from 1 October through 8 November. This average dropped sharply by 61% to Rs824 crore in the 53-day post-demonetization period.
The number of projects announced per day halved from six to three. Earlier, CMIE had estimated that the cost of the demonetization exercise to the government and RBI will be Rs16,800 crore.
There are at least four kinds of costs the government and the RBI have to bear in the exercise. First, they have to print new currency notes; second, they would have to bear the cost of transporting the new currency notes to all bank branches, post offices and ATMs; third, the government will have to compensate highway toll agencies that had been asked to make use of the roads free; and fourth, they have their own costs in terms of human resources and corresponding overheads.
Though there is near consensus on demonetization adversely impacting the Indian economy, experts and agencies differ on the extent and duration of the impact .
Moody’s Investors Service said on 24 November that demonetization will “significantly disrupt economic activity" and lead to weaker growth in the near term although in the long run, it can boost tax revenue and translate into faster fiscal consolidation.
Standard & Poor’s, in a report on 15 December, said it expects both demonetization and the goods and services tax (GST), due for implementation this year, to adversely impact some sectors of the economy in the short run, although both hold the promise of long-term benefits. S&P revised its growth forecast for India to 6.9% in 2016-17 from 7.9% earlier.
“In the long run, demonetization and GST could result in a wider tax base and greater participation in the formal economy. This should benefit India’s business climate and financial system in the long run," S&P said.
Also read: The silent suffering of Bharat
In the short term, the rural and informal sectors of the economy are experiencing large-magnitude adjustments. Business sectors that often transact in cash, including jewelry and real estate, will face some degree of upheaval, S&P cautioned.
Former chief statistician of India Pronab Sen said the real impact on production will be reflected in the Index of Industrial Production data in December and in the fourth quarter (January-March) of 2016-17.
“The pain people have gone through to withdraw cash is nothing when compared to the fall in production activity and loss of employment that is happening. The problem is we would not know the real impact of demonetization quickly. For now, we can only do guess work as to how long the impact will linger on," he added.
After the demonetization drive ended on 30 December, the government brought in an ordinance prohibiting people from holding or transacting in old Rs500 and Rs1,000 notes, specifying heavy fine. It allowed citizens not residing in India between 8 November and 30 December to deposit up to Rs25,000 till 30 June.
“The government should use this money to stimulate demand in the economy," said D.K. Srivastava, chief policy adviser at EY India. “While pre-demonetization there was investment contraction, post-demonetization the economy is also experiencing consumption contraction. The budget should focus on revival of demand in the economy as the private sector will take time to respond."
The finance ministry said once the grace deposit period gets over, the liabilities of RBI and the guarantee of the central government towards specified banknotes will stand extinguished. This is expected to lead to a one-time dividend to the government from RBI, though critics maintain with most of the Rs15.4 trillion demonetized notes coming back to the banking system, the government is unlikely to make any major gain.
The government has maintained that a mere deposit of money into bank accounts does not make it legal and it will seek accountability for the money deposited. PTI reported that between 10 November and 23 December, so-called Jan Dhan accounts meant for the poor and previously unbanked saw a sharp increase in deposits by Rs41,523 crore—the government believes these accounts have been misused by tax evaders to deposit illicit money.
The government has introduced an income disclosure scheme starting 17 December. Under the scheme, a person declaring undisclosed income needs to pay a tax of 30%, a penalty of 10% and a cess of 33% on the tax—all of which add up to around 50%. In addition, the person will have to deposit 25% of the undisclosed income in a zero-interest deposit scheme for four years. He needs to furnish his permanent account number (PAN) while making his declaration. Part of the proceeds of the scheme will be used for welfare schemes for the poor.
The punitive approach towards the dishonest will be accompanied by a softer one towards the poorer sections genuinely hurt by demonetisation.
The prime minister on 31 December announced a slew of measures that would benefit the poor, lower middle classes, senior citizens and small businessmen. They include cheaper loans for housing, businesses and stable savings rates for senior citizens. A day later, on 1 January, finance minister Arun Jaitley said providing capital at affordable rates using the black money that has come into the banking system will be on the future agenda of the government.
Following the cues from the government, soon after Jaitley’s statement, banks started cutting lending rates after the massive inflow of deposits spurred by the demonetization of high-value banknotes led to a significant reduction in their cost of funds.
State Bank of India (SBI), the country’s largest lender, cut its marginal cost of funds-based lending rate (MCLR) across all tenors by 90 basis points (bps), the steepest cut in several years. The six-month MCLR is now 7.95% and the three-year rate stands at 8.15%. One basis point is one-hundredth of a percentage point. MCLR is the benchmark lending rate at which a bank prices all its loans. Other public sector lenders Punjab National Bank (PNB) and Union Bank of India (UBI), too, brought down the benchmark interest rate.
PNB cut its one-year MCLR rate by 70 basis points to 8.45% from 9.15%, effective Sunday. UBI reduced its MCLR by 65-90 basis points to 8.65%. The revised one-year MCLR stands at 8.65%.
The government hopes consumption, which has so far been the key driving force of the Indian economy and has been hurt by the cash crunch, will pick up with lower interest rates.
Demonetization and the resultant cash crunch threw up an opportunity for the government to push digital payments and promote a cashless or less-cash economy.
India’s high cash-to-gross domestic product (GDP) ratio of around 12% is one of the highest among developing countries.
The government hopes the reduced use of cash and encouraging more electronic transactions will help create a digital trail of all transactions and curb the creation of black money. This will, in effect, increase the tax base and add to tax revenue.
RBI did away with MDR (merchant discount rate) charges on small transactions made digitally from 1 January to 31 March in order to encourage digital transactions. Going ahead, the MDR for debit card payments, including for payments made to the government, will be capped at 0.25% for transactions up to Rs1,000 and 0.5% between Rs1,000-2,000, RBI said in a notification. The existing MDR cap is 0.75% for transactions up to Rs2,000 and 1% for over Rs2,000.
Prime Minister Modi has launched an app called BHIM (Bharat Interface for Money) that can be used by citizens for making digital transactions and payments. To incentivize digital payments, Modi has also launched two digital lottery schemes: Lucky Grahak Yojana and Digi-Dhan Vyapar Yojana.
The government also appointed a high-level panel comprising six chief ministers and experts such as Nandan Nilekani, former chairman of the Unique Identification Authority of India, to chart out a road map for the adoption of digital modes of payment.
The government also sought to reduce the tax burden on small traders, who have seen their business shrink, by allowing small merchants with sales of up to Rs2 crore to pay less tax on financial transactions that have been carried out digitally.
Under the Presumptive Taxation Scheme under Section 44AD of the Income-Tax Act, 1961, such entities will now pay a lower 6% of deemed profit in tax instead of the current 8% in respect of the gross receipts through banking channels or digital means for fiscal 2016-17. The existing rate of 8% will continue to apply for cash receipts.
Since Day One, demonetization was a flashpoint for confrontation between the opposition, particularly the Congress party and the ruling Bharatiya Janata Party (BJP). One casualty was the winter session of Parliament, which was a washout.
According to New Delhi-based PRS Legislative Research, the month-long winter session was the least productive in the past 15 years.
As the policy unfolded in the 50 days till the deadline for depositing the demonetized Rs500 and Rs1,000 notes, it pushed forth the anti-corruption narrative of the National Democratic Alliance (NDA), which tried to position it as the “beginning of the end" of the fight against corruption and black money.
Crucial state assembly elections due in the new year, including in Uttar Pradesh, India’s most populous state, will inevitably be seen as a referendum on demonetization.
“Demonetization has undoubtedly been a game changer. The big question is if this game changer will lead to a self-goal for the BJP, but I am not sure that will happen. It has a lot of potential to give huge political dividends if it had taken the original scripted course," said Sandeep Shastri, political analyst and pro-vice chancellor of Jain University, Bengaluru.
Also read: 50 days of demonetisation
The government appears convinced that it has popular backing.
Prime Minister Modi said in his New Year’s eve speech that he had received letters from many people who “shared their pain and sorrow with me, but also emphasized their support" for demonetization.
“In this fight against corruption and black money, it is clear that you wish to walk shoulder to shoulder with us. For us in government, this is a blessing," Modi said.
Demonetization has already become a talking point in the Uttar Pradesh poll campaign.
Goa, ruled by the BJP; Punjab, where the BJP shares power with the Shiromani Akali Dal, and Congress-ruled Uttarakhand and Manipur also go to polls early this year.
“State polls are still two-and-a-half months away. Trends show that the BJP has gained goodwill among most sections. We will have to wait and see how the implementation pans out over the next two months; if it goes smooth, then I will not be surprised if the BJP capitalizes (politically) on it. However, if any major inconvenience continues, it has the potential to nullify the goodwill earned by the government, particularly on the issue of anti-corruption and black money," Shastri said.