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10 ways demonetization of 500 and 1000-rupee notes affects the economy
There are those who hail it. And there are those up in arms against it. But one thing’s for sure: Prime Minister Narendra Modi’s announcement to demonetize the 500 and 1,000-rupee notes came as a knockout punch.
Everybody – from the richest to the poorest in the street – is affected. Even over a week after the announcement, you can see thousands standing in queues outside banks. And this is likely to continue until December 30th.
But, it’s important to look beyond the short-term cash crunch.
Here’s a look at how the demonetization affects the entire economy in the short and long term, as per a report by Crisil, a credit ratings agency:
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Government revenues to increase:
A lot of money – that was hoarded as cash – was earlier unaccounted for. As people start depositing their money reserves, this money will enter the banking system. People will then be liable to pay more tax. This is a direct source of revenue for the government. This can have a medium-to-long term impact too. People may be discouraged to hoard a lot of cash.
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Fiscal deficit to narrow:
As the government’s revenues increase, its fiscal deficit—the amount by which it spends more than it earns—is likely to narrow. However, this is likely to happen in the medium-to-long term, not immediately. This delay is because the Income Tax Department can take time to claim tax on the deposits made by people, the Crisil report said.
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Public investments to rise:
Higher tax collections will now allow the government to further increase infrastructure spending, the Crisil report said. This is even more important considering investments by private players remain weak. Investments are crucial for the economy to grow.
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Economy to grow :
In the medium-to-long term. In the near term, the Gross Domestic Product (GDP)—a measure of the economy—could see a dent. This is because people could cut down their expenditure due to a cash crunch. This could affect the sections of the economy—the unorganised sector, for example—that deals only in cash.
However, as the new 500 and 2000-rupee notes enter circulation, the consumer spending could stabilise. Moreover, an increase in investments by the government could lead to higher employment and income. This could buoy the economy.
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Inflation to fall near-term:
When people cut down expenditure, demand for goods and services falls. Companies could announce more discounts to woo customers. All this could lead to a fall in prices. However, this is likely to be a short-term effect. The demonetization is likely to have minimal impact in the long term, according to the Crisil report.
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Liquidity and banks:
Deposits are a cheap source of funds for banks. They use this deposit money to lend at higher interest rate and pocket profits. This is especially crucial for banks that have a low base capital. This is non-deposit money that a bank has. So, the increase in deposits due to demonetization could increase the liquidity in the system. This could also reduce the negative impact of the redemption of foreign currency deposits by Non-Resident Indians that were due in the September-November 2016 period.
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Interest rates:
A high amount of liquidity in the banking system means banks and other players can buy more bonds. This could drive up the prices of bonds in the near futures. As prices rise, yields could fall. This is a short-term effect. In the long term, the government’s lower fiscal deficit could help keep interest rates lower, as per the Crisil report.
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Current Account Deficit:
This is a mixed bag. In the short term, as people face a cash crunch, demand for gold could fall. This is because 80% of the demand for gold is via cash, the Crisil report said. However, in the long term, people may want to hoard gold instead of cash. This could drive up gold imports. A higher import bill means a larger Current Account Deficit (CAD)—the amount India owes the world in foreign currency.
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Digital payments:
The demonetization influences people to make more transactions online. This could be through cards, wallets or simple bank transfers online. This shift in preference could increase in future as more people opt for non-cash modes of payment.
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Sectors affected:
Three sectors are likely to be highly affected: Real estate, jewellers, cement. These are sectors where a lot of cash transactions take place. The auto sector could see a marginal fall in demand for luxury cars and two-wheelers, which are often purchased using cash. Even the steel sector could be affected because 30-35% of their consumption comes from the real estate sector. The biggest beneficiary is likely to be the retail sector. Despite a short-term punch, the sector could benefit from the move towards a cashless economy in the long term.
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86%
It’s common knowledge that Indians prefer to use cash for payments. Other options like debit and credit cards, payment wallets, online transfers have low usage in India. This can be seen in the fact that 86% of the total consumer payments used cash, as per the Crisil report. This, however, is 2012 data. The proportion may have gone down in the last four years thanks to the rise in electronic transactions. But, cash still remains the king of transactions.
