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File photo: PTI
File photo: PTI

Opinion | Demonetization déjà vu in today’s coronavirus times

Three hidden themes from the 2016 note ban could play out again, but on an even larger scale

First things first. While both demonetization and covid-19 had a large economic impact, by no means are they of the same magnitude. There are parallels for sure, and even some lessons, but there are important differences too.

The shock from the scrapping of high-denomination banknotes in November 2016 lasted a relatively short period, as new bills were issued within weeks. While a shortage of cash for some time did unsettle the economy, factories never stopped and services kept going. But in the case of covid-19, it has already been four months of a full or partial lockdown, with no clear end in sight. And this time, the production of goods and services has been hugely disrupted.

As such, the economic consequences of covid-19 are likely to be greater and grimmer than those of demonetization.

We learnt three important lessons from the demonetization period, which weren’t obvious at first, but became clear in hindsight. These could play out during the current pandemic, but on a larger scale. Understanding them could help avoid pitfalls.

First, workers will find jobs again, but at lower wages. During demonetization, the unemployment rate declined gradually, but was driven by a rise in rural more than urban employment—rural India created double the jobs than urban India did. And despite the employment rate rising, wage growth declined over this period.

What could this mean? On an aggregate level, while workers were going back to work, the wage outlook was not as good as before. One explanation is that urban job opportunities waned and some workers were only able to find work in rural India, where wages are 40% of those in urban areas.

It’s a similar picture this time around. There’s been an improvement in labour markets between April and July, driven by a faster rise in rural jobs (though some of this could just be seasonal). And the nature of the pandemic is such that several urban-focused sectors such as restaurants and tourism will continue to hurt more, weighing on urban jobs and overall wage growth. The latter was already slowing before the pandemic, and could slow further, leaving the country in a low-growth, low-wage equilibrium.

Second, the ongoing shift towards a formal economy could reverse. About 90% of India’s labour force is employed in the informal sector, which depends largely on cash and does not have enough buffers to withstand large economic shocks. Demonetization is likely to have hurt the informal sector more acutely, with business expected to have dried up for some time, given the non-availability of cash.

In fact, when we looked closely at the performance of 2,705 listed non-government non-financial companies—which all operate in the formal economy—we found that post-demonetization, corporate sales suddenly began to rise much faster than the state of the economy would suggest.

This indicates that sales which previously took place in the informal sector moved to the formal economy. This trend may play out again. We are already seeing anecdotal evidence of large companies gaining market share in select sectors.

This formalization trend may have also pushed up equity markets during the demonetization period, as it is doing now. But did the formalization back then last?

Alas, it did not. By the middle of 2017-18, the sharp uptick in formal corporate sector sales began to fall back to pre-demonetization levels. One reason for this could have been a recovery in the informal sector—its businesses tend to have not just a high death rate, but also a high birth rate, which lets it spring back up.

The learning may then be that the formalization that happens on the back of a crippled informal sector is not as long-lasting as when it happens organically, like when informal firms graduate to formality on the back of a supportive ecosystem.

Buoyant capital markets should, therefore, be careful in assessing the sustainability of the current formalization process.

Third, it is likely that economic growth over the next few months would get overstated. When the government first estimates gross domestic product (GDP) growth, it assumes the informal sector growth rate—which is hard to capture—to be similar to the formal sector’s. This works fine in normal times, but not if the two sectors are diverging, as happened during demonetization and is happening now under the pandemic.

So what happened to GDP growth during demonetization? For the first few quarters after demonetization, it remained surprisingly high. But throughout this period, the government used formal sector growth as a proxy for the informal sector, thereby arguably overstating GDP growth.

India only gauges the informal sector once in five years through a survey, and then revises past GDP growth data. Unfortunately, the last survey was conducted before demonetization. As such, India’s GDP numbers since demonetization do not capture the true state of the informal economy.

This time too, GDP releases may not fully capture the actual weakness in economic activity, until it is updated with a new informal sector survey that’s still a few years away. Policymakers need to have a better way to capture informal sector growth, perhaps with an annual informal sector survey.

All said, these three post-demonetization themes need careful monitoring, especially as they threaten to cast an even bigger shadow over India’s economy than before.

Pranjul Bhandari is chief India economist at HSBC

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