The Modi Government on November 8, 2016 demonetized Rs.500 and Rs.1000 notes amounting to Rs.15.44 lakh crores which accounted for around 85 per cent of the cash in circulation. The last date for surrendering the demonetized notes to the banks in the normal course was December 30, 2016. The Government was probably hoping that around Rs.2 to 4 lakh crore worth of notes in circulation would not be surrendered to the banking system, thus leading to a windfall gain for RBI and in turn the Government. However, according to unofficial reports, most of the demonetized money has come back to the banks. According to a report by Bloomberg, quoting sources in the know, banks have received 14.97 lakh crore rupees ($220 billion) as of December 30. Thus it would appear that the windfall gain would not occur, and the RBI/ Government could hope for around Rs.0.50 lakh crore to Rs.1.00 lakh crore of demonetized money not to be claimed by the holders.
As against this, an initial estimate made by the Centre for Monitoring of the Indian Economy (CMIE) arrived at a figure of Rs.1.28 lakh crore as the cost of demonetization, which included the costs of printing and distribution of new notes as well as production losses in the economy. However, as on December 30, the amount of notes re-issued was only about 44 per cent of the surrendered amount. This would mean that it will take another couple of months for the situation to normalize, which would imply more pain to the economy.
Does this mean that demonetization has failed? We should not arrive at a hasty conclusion. Some of the money that has come back is black money. Most estimates indicate that about 20 to 25 per cent of the money in circulation in high denomination notes was black money, i.e. about Rs.3 to 4 lakh crores. This means that the tax authorities would have to follow up on suspect deposits to identify the black money and then impose penalties, which could amount to about 85 per cent of the money deposited plus penalties. However, identifying this quantum of black money is a humungous task for the Income Tax Department.
Further, the Government gave an option to pay 50 per cent tax on the unaccounted money, provided it is from a legitimate business and not from drugs/smuggling/terror etc. The Government would keep 25 per cent of the amount interest free for four years, and tax payers would have 25 per cent of the money in white initially, and a total of 50 per cent in four years. Some tax avoiders are expected to take advantage of this scheme also. So finally, adding up the money not surrendered to the additional tax collected, would probably lead to an overall gain of around Rs.1 to 2 lakh crores.
The hoped for long term gains to the economy include lower corruption, less money available to terrorists, removal of fake currency, faster transition from cash to digital payments, more taxes leading to lower fiscal deficits, more deposits for the banking industry, lowering of interest rates, fairer elections, etc. However, all these gains would be ephemeral, unless there is follow up action. In fact, the note exchange system led to increase in corruption among some bankers and middle men! Also issuance of Rs.2000 notes will help black money generators to hoard their ill-gotten wealth more easily.
The short-term pain for the economy is substantial. There have been considerable job losses for daily wage earners in some sectors. Vegetable and fruit growers have suffered. Standing in long queues has obvious implications on productivity. Purchasing Managers Index (PMI) data shows that both manufacturing and services have contracted in December. The informal sector has probably suffered more, but corporate margins will also be hit. During the period April-December 2016, bank credit growth was only 5.1 per cent, the lowest in decades. D.K.Joshi, chief economist of CRISIL, the country’s leading credit rating agency, attributed the drop in credit growth to demonetization. According to CMIE, new investment proposals have also suffered because of demonetization, as businessmen are not certain when the economy will rebound. “New investments worth Rs.2,097 crore were announced, on an average, per day during the 39 pre-demonetization days from October 1 through November 8. This average dropped sharply by 61 per cent to Rs.824 crore during the post-demonetization period. The number of projects announced per day dropped from 6 to 3 by a similar comparison,” CMIE said. Even before demonetization, not much fresh investments were taking place, and the economy was being driven mainly by consumption push. Demonetization has led to lowering of consumption, at least in the short run.
After standing in lines for nearly two months, the rush at banks and ATMs are thinning out and people have started getting cash in their wallets. And since the banks are flush with surrendered money, they have slashed interest rates on homes, cars, personal loans as well as corporate loans. So, borrowers have reason to smile, even though depositors will earn lower interest rates.
In a few months’ time, we will know whether demonetization will be a success, and that the plan has not left any major scars on the Indian economy. A lot will depend upon whether GDP losses on account of demonetization will be limited to around 0.5 per cent of GDP or will be larger. Given India’s current GDP of around Rs.150 lakh crore, every per cent point lowering implies a cost of Rs.1.5 lakh crore.
As of now, Mr. Modi seems to be winning the perception battle among ordinary citizens as he has been willingly to take a risk by going after the corrupt and the undeserving rich.