People stand in a queue to exchange their old Rs 500 and Rs 1000 notes at the State bank of Hyderabad, Dadar.(Pratik Chorge/HT Photo)
People stand in a queue to exchange their old Rs 500 and Rs 1000 notes at the State bank of Hyderabad, Dadar.(Pratik Chorge/HT Photo)

Study says demonetisation may spell doom for the economy: Here’s why

The Economist has said the note ban could turn out to be the worst mistake of PM Modi’s career. Some experts have even said that if the move does not produce the intended effect, it can plunge the economy into recession.
By Ramanvir Grewal, New Delhi
UPDATED ON NOV 23, 2016 02:01 PM IST

National Institute of Public Finance and Policy (NIPFP), a think tank affiliated with the finance ministry, has warned that the shock move to demonetise Rs 500 and Rs 1,000 currency notes could lead to “a contraction of economic activity in the economy” and social unrest.

Prime Minister Narendra Modi’s decision to scrap high-value notes that accounted for 86% of the currency in circulation has triggered cash chaos. People have been forced to line up for hours, sometimes overnight, outside banks and ATMs to get cash across the country.

Realty, gold and the informal sectors have been hit the hardest as they rely heavily on cash. The situation is worse in villages where a large number of people are unbanked.

Read | Demonetisation fallout: Experts warn note ban will slow down Indian economy

The move has united the opposition, drawn criticism from experts, the public, and even the Supreme Court that said the problem was very serious and that “the country will have riots on the streets”.

The NIPFP’s recent paper examined the very short-term, short-term, and medium-term impact of the move on the economy. It said the impact in the medium term is dependent on how much of the currency will be replaced and how much of it is extinguished.

The paper said if the extinguished currency was being used as a medium of exchange in legitimate economic activity, then the economy would contract. It also said if the incomes and consumption continue to be compressed, there could be social unrest.

Supporters of the Aam Aadmi Party (AAP) protest against demonetisation, in New Delhi. (AFP Photo)
Supporters of the Aam Aadmi Party (AAP) protest against demonetisation, in New Delhi. (AFP Photo)

It added if the extinguished cash is being used in accounted transactions and the informal sector, then the impact on the economy could be substantial, resulting in a closing down of these activities. This would lead to a reduction in incomes and employment.

The effect could then spill over to the organised sector as consumption from the incomes generated would be linked to it.

Immediate impact

Since money supply has been severely contracted, certain sectors will be hit hard as cash transactions will stop. As income and consumption are closely linked to transactions, they would be severely contracted.

People’s purchasing power would be lowered resulting in a reduction in demand since they are left with no case. The report said though some may presume that prices will fall as supply would exceed demand, there is a possibility of prices rising if supply too is curtailed.

Read | Demonetisation will lead to 6 months of chaos: Ex-RBI deputy guv Chakrabarty

Short-term impact

The report said if the entire currency is not replaced soon, a few sectors such as agriculture, automobiles and construction will be affected.

It is the sowing season for the Rabi crop in some parts of the country and the harvesting season for the Kharif crop and most purchases and sales in the segment would be made in cash. The report said farmers would find it difficult to sell their Kharif crop due to the cash crunch.

People line up outside banks to deposit and exchange cash at the Oriental Bank of Commerce, Gandhi Nagar in New Delhi. (Sonu Mehta/HT Photo)
People line up outside banks to deposit and exchange cash at the Oriental Bank of Commerce, Gandhi Nagar in New Delhi. (Sonu Mehta/HT Photo)

This would then affect their bargaining power, preventing them from getting a good price. Whereas, those planning to sow won’t get access to inputs. So the farmer won’t be able to reap the full benefits of a good monsoon.

Medium-term impact

The report said though the move will result in a surge in bank deposits, bank lending wouldn’t go up as there is little demand for credit. It further said if the demand for credit is not sensitive to interest rates, then banks could take more risks while lending.

The housing loan bubble of the US economy might be one such example of lending to more risky projects, thereby bringing in more volatility into the system.

Corrective measures

Experts have said that most people with large amounts of black money do not keep it in cash. So the government still has the opportunity to take corrective action. It can either roll back the move or allow people to use the old currency notes for a few more months, or even postpone the deadline to submit them.

Read | No ‘one-time gain’ for govt from demonetisation, at least in 2016-17

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