UGP Project-Report. Demonetization and Its Impact on Indian Economy. ECO399A Rakesh Jangid (14531) Prof- Dr. Sohini Sahu

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1 UGP Project-Report Demonetization and Its Impact on Indian Economy ECO399A Rakesh Jangid (14531) Prof- Dr. Sohini Sahu Brief Introduction of Recent Demonetization On the evening of 8 th November 2016, Indian Prime Minister Mr. Narendra Modi announced a sudden denomination of 500 and 1000 rupee notes. Instead of RBI Governor Urjit Patel, surprisingly Prime Minister announced the news of demonetization that these banknotes would not be legal tender after midnight of the 8 th November. means the high value notes will not be legal for transaction. Although the old notes can be exchanged till 31 st December There were set an upper limit of cash withdrawals from bank is 10,000 per day (up to 20,000 per week) per account and from ATM 2000 per day per account from 10 to 13 November which is changed from 14 Nov. to 24,000 per week from bank and 2,500 per day from ATM per account till 31 st Dec., although a needy person can withdraw with valid reason. According to RBI report on 31 st march 2016, 500 and 1000 banknotes consist around 86% of total cash circulation having value of lakh crore. In this process 97% of old notes around lakh crore were deposited in bank before 31 st December. Motivation In last year, Demonetization was a major economic incident and a bold move by the government. As soon as the PM announced about demonetization, a debate started in the whole country. On the news channel, at the offices, everywhere everyone wanted to understand the effects of demonetization as it was not so obvious. I was also one of them who were interested, curious and excited about the recent event. I thought that I should understand the economic point of view of such a big event as economics student. All these things inspired me to dig into this topic. Objective of the Study The aim of this study is to study the previous instances of demonetization round the world. In these cases, what were the aims of the countries and what happened to them next, is also collected in the study to understand the possible outcomes of our demonetization to reduce the negatives and to maximize the positive ones by learning from the good decisions taken by the various countries as well as by the mistakes made by them. This study also takes the views of many other authors and collects them to make a perspective about the possible effects of the demonetization, explanation of them according the economics theories and suggestion made by them. One of the most important part of this paper is the one where broker s fee concept is used to explain the behavior of people at the time of demonetization, and the effect of it further on savings and investment. 1

2 This study would help in understanding the cost benefit analysis of demonetization in India. This study would also help in finding out the sectors that are affected due to demonetization and appropriate actions could be taken by the government by modifying the policies accordingly. This study also shows the way to government to take the decision by observing the objectives and the results of demonetization done in many countries in past. History of Demonetization in India and the World In India, there were many occasions when high denomination banknotes were demonetized. RBI printed the highest denomination notes of 10,000 in After that government demonetize 1,000 and higher denomination banknotes in Higher denomination banknotes ( 1,000, 5,000, 10,000) reintroduced in 1954 and all of them were demonetized in 1978 to curb unaccounted money. First time 500 banknotes were introduced in 1987 in order to restrain over increasing banknotes, due to inflation and in 2000 again 1000 banknotes came back in circulation in order to contain the volume of bank notes in circulation, due to inflation. However, 2,000 banknotes were first time introduced in Nov Along with India many countries in the world had done demonetization in the history. Almost countries that had done demonetization had some common objectives of demonetization which were to curb corruption and black money and their government decided to demonetize their higher denomination notes to rid of these problems. Here is the list of some countries that had done demonetization: List of countries in the world that had done Demonetization Country Name Year Objective Results Nigeria 1984 To fix, debt burdened and inflationridden economy Soviet Union 1991 Fight against unearned income, smuggling and corruption Economy collapsed The economic system of the USSR was essentially crushed Ghana 1982 To control black money People turned to foreign currency Myanmar 1987 To curb black money led political dispute and died thousands of people North Korea 2010 To lower down the market of black Miserably Failed money Zimbabwe 2010 Sliding out from Hyperinflation Failed 2

3 GDP growth Australia 1996 To the curb black money crisis and Success improve security features on the notes Britain 1971 To bring uniformity in currency failed in other countries except Britain Zaire 1990 A plan to withdraw obsolescent Failed currency from the system USA 1969 Due to black money Success Pakistan 2015 To get rid from Black Money, Messed Up Counterfeit Currency Germany 1923 Due to high domestic prices Inflation fell Philippines 2016 To preserve the integrity of currency -- By investigating the table, we can observe that most of the countries that have done the demonetization, have failed miserably in doing that. The main reasons behind the success could be the behavior of Indians to find a way to show patriotism and the belief of Indian people in their strong government. Other than this observation, we can see in the table this table. GDP Growth Rate in Pre, During and Post Demonetization Periods Nigeria Ghana Soviet Union Zaire Myanmar Australia United States of America Britain Country & time periods Pre During Post Data source- World Bank By collecting the growth rates of the countries, which has done the demonetization, at the time of demonetization show that most of the countries lost a lot of growth due to that. Nigeria had a negative growth rate during demonetization and before demonetization year so their 3

4 economy collapsed at that time but after the demonetization they grew at higher rate. Other than this Australia was pretty stagnant in terms of growth rate in pre-and post-demonetization period. United States and Britain felt a slowdown in the growth rate during demonetization year but after they grew at higher rate. Many other countries also done the demonetization when they had high negative growth rates in the following years, so they couldn t succeed and their economy collapsed. By this we can understand that it is pretty hard to sustain the growth, and we should be aware and alert of that fact and should take appropriate actions, otherwise the story would remain the same for us also. Studies on Demonetization/ Literature Review i) Theoretical Analysis of Demonetization by Dipankar Dasgupta explain the effect of demonetization on GDP growth by IS-LM Model- Goods market equilibrium using Equation- Y = C (Y, i + ρ, e, φ, W) + I (i + ρ, e) + G Where consumption depends on (a) Φ- confidence variable (confidence in governments actions) (b) e- demonetization impact on agricultural production and harvesting etc.(c) W-total wealth, (d) bank loan interest rate ib = i + ρ and if ib fall then demand for durable goods increase. Negative impact on e, φ, W results IS Shifts to left. A fall in money supply results to LM shifts also left (increase sovereign rate of interest) also there IS shift leftward sharply so finally results is a fall in interest rate and output hence these factor leads to fall in GDP growth in 3rd quarter ii) Demonetization through Segmented Markets: Some Theoretical Perspectives by Parag Waknis explain the effect of demonetization on three markets Money Market, Goods Market and Labor Market (a) Money Market-Supply Side Demonetization reduce money supply in economy so M shift left, it s implies that consumers have less cash now so output s demand go down due to fall in consumption (in Goods Market) and graph of IS shift left and it results to a fall in real interest rate r, Now we look at the labor Demand side- firm have less cash during demonetization so they reduce their labor demand and its results to labor demand shift left and also output supply shift left. iii) Economic Rationale of Demonetization by Vineet Kohli and R Ramakumar. They talk about counterfeit currency, black money, fiscal space, and interest rate and inflation to estimate cost and benefit of demonetization in their research paper. Counterfeit Currency- According to Indian Statistical Institute (ISI) kolkata 2012 report estimate that total Fake Indian currency notes (FICN) in circulation was found about 400 crores. Black Money-In Indian Economy huge portion around 62% of its GDP are in black and a very few part of black money is in cash mostly black money are in the form of gold, Silver, Dimond, Residential Real Estate etc. Only 7% of total black money are in cash. 4

5 (Rupees in Billion) Fiscal space- During demonetization Govt generate came up with income disclosure scheme, In which Govt. offer that if someone voluntarily disclose his/her unaccounted income than they have to pay 50% tax on his disclosure and in addition they will provide an interest free loan of one fourth of his disclosure and total 1.6 lakh cores INR were disclosed during this scheme. Govt s total revenue calculation in present discounted value (PDV) PDV = 50%tax (1,60,000 crores) + interest on ¼*1,60,000 crores for 4 years = 80,000 crores + PDV of 2400 crores = 88,430 crores So, total fiscal revenue from demonetization is 88,430 crores. Cost of Demonetization 17,000 crore on printing and distributing + 6,000 crore as the interest cost of managing the excess liquidity with banks + 45,900 crores due to economic contraction = 68,900 crore. Now we can estimate total profit for the government = 88,430 crores- 68,900 = 19,530 crore. Analysis of Demonetization by Sectoral Data Trends QUARTERLY ESTIMATES OF GROSS VALUE ADDED AT BASIC PRICE IN 2016 (Base: ) Agriculture, Forestry and Fishing Mining & Quarrying Manufacturing Electricity, Gas, Water Supply & Other Utility Construction Trade, Hotels, Transport, Communication and Services Related to Broadcasting Financial, Real Estate and Professional Services Public Administration, Defence and Other Services Industry Q1 Q2 Q3 Note: Q1, Q2, Q3 & Q4 denote - April to June, July to September, October to December and January to March quarters, respectively. Source: Central Statistics Office (CSO). 5

6 Manufacturing Sector Manufacturing sector histograms in the above set of graphs shows that manufacturing sector has come down in the Q3. It is including the formal sector only, that s why it is only a small dump. Otherwise, it could have been a large dump because of a huge effect on the informal sector in manufacturing industry. At the time of demonetization, everyone was getting small amount of cash that was only good to make the daily expenses of a person and his /her family. Same was the case with the people that were running many manufacturing firms. They didn t have enough cash to pay their employers on daily basis. The supply of workers went down because they were not getting new notes to buy something by doing the work at firms. Some cases were seen those days of the firm masters giving the employers the old notes. That lack of the labor, lead to less production in manufacturing sector in Quarter 3. Real Estate By the graphs, we can see that In Financial, Real Estate and Professional services, there is a significant dump in the quarter 3. We can understand this scenario by observing the basic characteristics of these sectors. We know that in the real estate sector, most of the transactions of even very big deals are done through the cash. People don t prefer the online transactions in these cases due to the fear of various duties and taxes on big transaction to buy and sell properties. When the demonetization was done, people had lesser currency with them than that of normal days to do the transactions. A large chunk of black money is invested in the real estate, so real estate people had more currency than that of according to their real income. The people who had sold the property in recent time, had enough cash but they could not tell the source of that. That large supply of money was adjusted somehow by these people to change with the new notes and in this process, large chunk of currency went out of the market that is the essential lubricant to run the real estate smoothly. In this way, the loss was accounted due to very less activities. Now, we can understand that, Real Estate is most reactive sector towards economic policy changes like changing in Interest rate, Demonetization, Tax Reforms, Shrinking Stock Markets etc. Therefore, we can see above in the histogram that Real Estate market fell down in Q3 due to shorting of cash. Construction Trade, hotel, Transport Sector, Broadcasting Related services, Mining and Quarrying sectors output not changed in Quarter 3 because in these sectors a very few transactions are made in cash. Agricultural and Forestry Sector Agricultural output is not seen immediately as crop take time in growing. So, the data shown in the graph actually representing the output of the previous quarter. So, we would be able to see the effect of demonetization on agriculture only after the results are out for the next quarter. 6

7 Macroeconomic View We should try to understand that what happened in the economy due to the chaos created in the economy due to demonetization. Baumol (1952) tried to understand the transaction demand for money dependent on the interest rates and the pattern of the expenses procedure. We generally have two procedures either the receipts follow disbursements or the disbursements follow receipts. By taking both accounts when we perform the calculations then we find out that demand for the cash is not proportional to the value of transactions. Here is simplified equation of Baumol s model T = 2 k C + k C C2 Where T is value of total transaction, C is amount of cash withdrawal and k is transaction velocity of cash k = T/C If our transactions go up by a multiplier two than we don t need double cash but we need much lesser than that. From a different point of view, if we think that our total transactions go down by a multiplier half, our demand for the money has not come down to half of the previous one, we still need money more than half of the previous demand. This theory also has an implication that if a large area has the same currency notes as medium of transaction, then they need lesser money supply overall than the case of having different currency for the different regions. That implies that if the whole world has the same currency then the world would need lesser money supply than it has now. In perspective of India s demonetization, we can say that this concept was increasing the chaos because when the transactions were going down due to lack of money supply, still the need of money supply was not going proportionately down so we could transact even less than what was generally done with the money we had in the market at that time. We can understand this thing by the example that let s say we had 10 percent of the money supply than we generally have in our country, then we could do far less transactions than the 10 percent of the total transactions we generally could do with our money supply. By the model, we can also observe that the value people want to draw in one go is always positively related with the broker s fee. Baumol explained that the broker s fee is not only the charges we have to give to the bank or the other institution to withdraw the money. As there were many long lines outside the banks during the demonetization period, obviously, the broker s fee had increased for all the people, so everyone wanted to take away a big chunk of money in one go therefore there was a need to have an upper limit on the withdrawal limit and that was also done by the government. In a way, this thing also helped in pumping the money again in the economy because the people were withdrawing the money at the maximum limit. As the broker s fee was high, everyone wanted to withdraw high if they are going to withdraw but at the same time everyone wanted to avoid the withdrawing if possible. Other than this, 7

8 interest rates were reduced a bit to encourage the money supply in the country because lower interest rate leads to a high consumption that was needed at that time to boost the economy. Conclusion Initially Govt s Objective was to curb black money but if we look at the figure, 97% of 500 and 1000 rupees banknotes were deposited in banks and only 3% (.43 trillion rupees) black money scraped as undeclared income hence we can say a less part of Black Money is in cash so this action isn t effective to curb black money. However, Tax GDP ratio will increase in future. Due to demonetization counterfeiting currency market offhand shut down for a while but they have capability to create new notes duplicate so we can say in short run their activity will be slowdown but in long run they can rebuilt their market and also it is easy to handle 2000 rupees notes instead of 1000 rupees notes in briefcase to giving bribe. In this study, we have found some important points about the short-term effects of demonetization as well as about the long-term effects by observing the previous cases of demonetization in other countries. We have to be alert and thoughtful to sustain our growth because many countries which have done demonetizations could not sustain the same. In short run, almost all the sector in the Indian economy have been affected negatively due to shorting of cash. However, in long-run Informal Economy would be formalize. So, government have to focus on informal economy and need to make appropriate policies for them. Other than this, we have got the point by using the Baumol s model in this case that the transactions were more difficult to make than it could be simply estimated by the ratio of money supply in demonetization period to the normal period s money supply. Money supply reduction results to fall in interest rate and accessibility of loan will be easier as interest rate decrease. It will be helpful to new entrepreneur for their startup. After demonetization, Indian economy got the momentum towards Case less economy. Longterm effect of demonetization couldn t identify yet due to less availability of information set. 8

9 Data Source i) Data on GDP Growth of various countries is taken from World Bank website. We use three Conjugative years GDP to analyze the demonetization impact on their economy. ii) Various Sectors Quarterly Gross value added output data at basic price in 2016 (Base: ) is taken from RBI s official website (Reserve Bank of India). iii) Data on Demonetization in various countries is taken from various website -Economics Times s website - A word to the world s website -naukrinama s website References Dipankar Dasgupta. (2016, December 17). Theoretical Analysis of Demonetisation. Economic and Political Weekly, Vol ll No. 51. Vineet Kohli, R Ramakumar. (2017, January 4). Economic Rationale of Demonetisation. Economic and Political Weekly, Vol. 51, Issue No. 53. Kobad Ghandy. (2016, December 10). Demonetisation One Step Forward, Two Steps Back. Economic and Political Weekly, Vol ll No. 50. Arun Kumar. (2017, January 7). Economic Consequences of Demonetisation Money Supply and Economic Structure. Economic and Political Weekly, Vol lll No. 1. Parag Waknis. (2017, February 27). Demonetisation through Segmented Markets: Some Theoretical Perspectives, Economic and Political Weekly, Vol. 52, Issue No. 9. 9