Detailed Impact analysis of Demonetization – Long term Benefits Outweigh Short Term Pain

In the previous article, we saw a quick overview of the Demonetization scheme and its immediate impact on the citizens of the country. Over the past few days social media has been buzzing with posts and memes both pro and against the move. Before you decide whether you are For or Against this move by the Indian Government, I would recommend you read this article first. The purpose of this article is to help you understand the Detailed Impact this Demonetization move is going to have on the Indian Economy.

Note: This is not a politically motivated article and I am only going to analyze the impact from a purely economic stand point. Please refrain from making political comments irrespective of whether you agree with my views or don't. Thank you.

A Little Background:

The sudden and abrupt announcement by the government to make the currency notes of INR500 and INR1,000 invalid as legal tender from mid night of 8 November came as an absolute shocker to everyone. Though there were rumors aplenty that a new INR 2,000 note is on the cards, nobody expected that the Government is going to make the older notes of 500 and 1000 invalid. The Government has clarified its intent behind the move as an attempt to crack the whip on black money and face currency rackets across the country. 

This comes after a Partially-Successful attempt by the Government where they allowed citizens with Unaccounted Income to legally pay the requisite taxes and convert it to white. This scheme was called the “Income Disclosure Scheme or IDS” and has unearthed over 65,000 crore rupees. Considering the amount of black money that is supposed to have been stashed away abroad (or in cash houses in India) this number is quite small. Nevertheless, people will black money were given an opportunity to come clean and now the government has gone one step further to make all their illegal hoards of cash – WORTHLESS… 

Of course – the obvious unanswered question before we get into detailed impact is “What if people start hoarding the new 500 or 2000 rupee notes also?”

Reduced Currency Circulation and Supply – Short Term 

As a country where Cash is still the King and paperless payment means (cards, online etc.) are still not as widely used, this move to demonetize 500 and 1000 rupee notes is going to have a “Direct” and “Major” impact on the currency circulation. To make matters worse, about 86% of currencies being transacted belong to these denominations. This means, we are going to have short term difficulties in getting currencies for our day to day transactions. Banks are extending their operating hours, ATMs are being recalibrated to dispense the new notes and also being refilled multiple times every day to reduce the impact on the common man. However, we cannot deny the fact that, this is going to be a big inconvenience (at least for the first 1-2 weeks) for the citizens of the country. 

Impact on the Informal Sector – Short Term Major Impact, Long Term Medium Impact

You may be wondering what is meant by Informal Sector. 

According to Wikipedia - The informal sector, informal economy, or grey economy is the part of an economy that is neither taxed, nor monitored by any form of government. Unlike the formal economy, activities of the informal economy are not included in the gross national product (GNP) and gross domestic product (GDP) of a country.

Black Money is the lifeline of the Informal Sector of India. Millions and Billions of rupees get exchanged between buyers and sellers of Goods & Services in the Informal Sector but none of it comes under the tax radar. Some of the major industries in India that are part of this Informal Sector include, Real Estate, Construction, Jewelry etc. 

So, all Black Money Transactions that don't contribute to the nations GDP or pay taxes are going to be impacted directly. This is a good thing, isn’t it? 

Impact on GDP Growth – Short Term Medium Impact, Long Term Low Impact 

India has been one of the few developing nations that have been able to sustain their GDP growth momentum in the past few years at around the 8% mark. This sudden decline in money supply is definitely going to impact the consumption demand in the Economy in the short term. This coupled with negative impact on Real Estate, Jewelry and other Informal sectors, this demonetization could potentially lead to a slight lowering of our GDP growth targets. 

However, this shortage in currency supply is only going to be for the first few weeks and the system is expected to adjust itself to the new currency notes within one quarter. Experts predict that the growth forecast for our GDP would still be around the 8% mark or maybe dip slightly after this Demonetization move. 

There are some people suggesting that this reduced money supply might have a deflationary effect. As this short-supply is an interim situation rather than a long-term predicament, we cannot just say that this move will result in Deflation in all sectors of the Economy. However, whether the reduced money supply will just result in just a reduced demand or Deflation or a mix of both will vary from sector to sector depending on the nature of the goods or services under question. 

Impact on Hawala Dealers – Short Term Critical Impact, Long Term Medium to Low Impact 

The term Hawala is being used extensively these days by supporters of this Demonetization move. Hawala brokers and dealers have been dealt a very heavy blow where the tons of cash in 500’s and 1000’s they are sitting on, are worthless now. (Read more about hawala - Click here ). Unless they can find buyers for these worthless stacks of paper who are willing to deposit the money into their own bank accounts, these dealers are going to incur hefty losses. Hence the short term critical impact. As these dubious transactions usually go toward financing other illegal activities, this impact is going to be positive for the nation as a whole. 

Of course, the hawala traders and brokers will find a way to sustain & survive in the long run but will be wary of future Demonetization attempts and wouldn't be able to expand/grow to uncontrolled sizes as they are now… 

Impact on Fake Currency Rackets – Short Term Critical Impact, Long Term Low Impact 

Our country has been plagued with fake currency rackets that are trying to pump in fake 500s and 1000s from both east and west of our borders. With this sudden demonetization, they are now forced to figure out means to print out the newer notes and until they do, their activities are severely impacted. Not to mention, the piles of worthless paper they are sitting on which they just have to dispose off with no monetary benefits. 

Of course, this one time Demonetization isn’t going to eliminate these fake currency rackets but the fear that other currency notes may be Demonetized in future would be lingering in their minds and will prevent them from growing uncontrolled like they have become now. 

Hawala traders and fake currency rackets primarily fuel the growth of terrorism in most countries across the globe. There has been no news of stone pelting or stray violence incidents in the past 3-4 days. Maybe this Demonetization is having the impact on separatist groups who are paying people to cause such ruckus because all their money is worthless now. 

Impact on the Real Estate Market – Short Term Medium Impact, Long Term Low Impact 

This Demonetization move is unlikely to result in any long term major reduction in demand for Real Estate from end users. Do you wanna know why? Majority of people who are buying property are going for a Home Loan to fund their purchase. This group of buyers will continue to buy homes irrespective of this Demonetization move. However, demand from investors who are paying cash to buy a house (and register the property at a value that is much lower than its market price) might go down because of this Demonetization move. Of course, much of this cash-only type demand is on relatively higher value transactions of above 1 crore or more where people are trying to offload their cash reserves. Hence, this reduction in demand is expected to have only a minor impact on the Real Estate Sector as a whole. 

From a buyers stand point, this will result in stabilization of the prices that have been skyrocketing in the past decade because one of the fuelling factors behind the enormous growth of the Real Estate sector has been politicians and rich businessmen pumping in millions of their unaccounted currency with ease because they were able to transact in “All Cash” with no restrictions. Even with hundreds of thousands of apartments being unsold in gated communities in towns & cities across India, builders are willing to wait until they get a buyer for the price they are quoting because they are in no hurry to convert their black money to white. Small to mid-sized Builders and Real Estate developers who don't have access to black funds are the only ones who have had to reduce their prices to stay in business. 

On a related note, the Registration Prices for Real Estate might increase because, people have been able to register their property for prices that are much lower than they are worth because of the big cash component in the purchase. With this Demonetization, registration prices will go up and as a result, so will the tax revenue for the government. 

Impact on the Automobile Sector – Short Term Medium Impact, Long Term Low Impact 

This Demonetization Move will Definitely have a medium term medium sized Impact on the Automobile sector because a good chunk of buyers of automobiles still use cash (that is unaccounted for, of course) for their transactions. Like with the Real Estate sector, the demand from the middle-class that are taking Auto Loans to buy their cars or two-wheelers will continue to be the same. However, as the % of cash only transactions are higher than Real Estate sector, the impact is going to be medium sized rather than minimal. 

Between the first hand and second hand auto markets, the second hand market is expected to have a much bigger impact due to the higher proportion of cash transactions. 

Impact on Consumer Durables Sector – Short Term Medium Impact, Long Term Very Low Impact 

This Demonetization Move will Definitely have a medium sized short-term Impact on the Consumer Durables sector because a big chunk of buyers still use cash for their transactions. With increased usage of Credit Cards for purchase of consumer durables (coupled with easy pay EMI schemes offered by card issuers) this impact is only expected to be in the short term and will not be applicable after 3-6 months once money supply returns back to normalcy. 

Impact on Jewelry and Gems Sector – Short Term Major Impact, Long Term Low Impact 

Jewelry and Gems sector is expected to be impacted heavily at least for the next two to three quarters. This is because, a major chunk of the working capital in the industry comes from unaccounted cash & a large proportion of the goods being sold are uncounted for inventory. The industry has been able to sustain its business with heavy leverage on “Cash only” transactions and with only a few thousand rupees enough to buy gold jewelry or gems, this has been the easiest option for people to convert surplus black cash. 

In terms of impact also, we could split Jewelry traders into small sized businesses who operated in the informal sector with no accounting or taxes whatsoever and the medium to large sized businesses that have operate in the Organized sector with proper accounts maintained. This Demonetization is expected to have a short-term negative impact on the organized sector while the impact on the short-term unorganized sector the impact will be much harsher. 

In fact, ever since the Government announced its intention to Demonetize the 500 and 1000 rupee notes, there has been a mad rush to buy gold to try to salvage at least some of the black funds. However, the government has requested the CCTV footage from all jewelry shops for the past few days to track the tax evaders who tried to convert their black currency into gold. 

Gold imports through the unofficial channel are likely to reduceas well. There will be no significant impact on jewelry exporters because it is mostly an organized market and sales are againstproper invoices.

Impact on High End Retail Sector – Short Term Medium Impact, Long Term Low Impact 

As one of the industries with high proportion of cash transactions, the impact on high end fashion retail and luxury goods to be more pronounced as discretionary spending/demand in this segment will be directly impacted. Consumers who spend using plastic will continue to do so but those using cash for purchases are definitely going to be curtailed due to this Demonetization move. 

Impact on Education Industry – Short Term Major Impact, Long Term Low Impact 

Actually Education wasn't supposed to be an industry but has developed into one. One of the biggest hoarders of unaccountable cash are Schools and Colleges. Almost every single institution collects security deposits and donations without issuing receipts. All of this money goes into the unaccounted/black category. Though this Demonetization is not going to deter these institutions from continuing to collect such donations, at least this move has dented their coffers and will result in heavy losses for those tax evaders. 

Impact on Restaurants and Services Industry – Short Term Medium Impact, Long Term Very Low Impact 

As yet another industry that is heavily cash driven, Restaurants and small shops where individual transactions are barely one or two hundred rupees, are going to be significantly impacted. Statistics suggest that at least 70% of all such transactions are currently in cash so the likely short term impact is going to be moderate. However, with all shop owners moving towards card reading POS machines, the impact wouldn't be as bad as it is being portrayed. Plus, with the cash flow being restored slowly, this impact should gradually become non-existent in the next few months. 

Impact on Bank’s Liquidity & Compliance Reserves – Positive 

We all know that Banks collect deposits from customers who have surplus cash and loan them out to customers who need it thereby making a profit in the middle. Banks in India have been plagued with bad loans on their books (No, not just Vijay Mallya, Banks in India have many thousands of loan defaulters) and have been struggling to cope with the losses. This Demonetization means, people with cash holdings are now forced to deposit their money in their respective accounts. Even if people with a lot of black cash just deposit the minimal 2.5 lakhs to evade tax scrutiny and only a few thousand people do it, imagine the thousands of lakhs of additional liquidity Banks are going to have? 

All this extra cash is going to get infused into our economy (by means of loans to businesses) and eventually impact our economy and GDP positively. Not to mention, the government doesn't need to infuse cash to meet the liquidity and regulatory requirements of our Banks. 

Impact on Bank Lending Rates – Short Term Negative Impact 

The sudden influx of is structurally a positive for banks as a big part of this cash gets deposited as current account and savings account (CASA) deposits, reducing banks dependence on higher cost borrowing. Deposit deployment will remain a challenge in the short to medium term for banks because, demand for loans may not meet the amounts being deposited. This could result in a short term fall in deposit rates but should stabilize soon. 

Before we Finish:

There are some educational institutions/small companies/businessmen who are forcing their staff to deposit 1-2 lakh each into their respective bank accounts and asking them to return it in future by citing their continued employment as a threat. Though this is illegal it is still happening because the government isn’t planning to scrutinize accounts where the deposit is lesser than 2.5 lakhs. As employment is at stake, most of us would probably do it as well because at the end of the day we all need to feed our families. However, am hoping that, just like the Government asked for CCTV footage from jewelry dealers, they do something to punish such black money hoarders… 

Some last words: 

As you can see from the article, the short term pain with regards to getting enough cash for our day to day needs is going to exist for the next few weeks until cash flow stabilizes and banks are able to refill ATMs with enough notes. However, if you see the long-term impact most sectors have very low or low impact. On top of this, there is going to be liquidity infusion in banks, additional tax revenue for the government as well as heavy impact to illegal and anti-national elements (terrorist financers/hawala traders/fake money rackets). 

All in all, I feel the long term benefits outweigh the short term pain. As responsible citizens of the country, we should try to support our government in this commendable effort to reduce black money.

Jai Hind!!!