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Demonetisation can permanently damage India’s informal economy
November 27, 2016, 10:32 am

On November 8, Indian Prime Minister Narendra Modi announced that ‘the 500 rupee and 1,000 rupee currency notes presently in use will no longer be legal tender from midnight’.

This step of demonetisation was taken ostensibly for curbing black money and counterfeit currency notes.

As per Reserve Bank of India (RBI) figures, the higher denomination notes of Rs 500 and Rs 1000 constitute 86.4 per cent of the total currency in circulation in the economy, by value. Therefore, with the stroke of a pen, the government nullified 86 per cent of the currency in the economy.

This huge monetary shock to the economy has both short-term and long-term effects.

Firstly, such withdrawal of money supply in the economy has drastically reduced transactions and exchanges, primarily for those sectors which use cash.

With a fall in transactions, economic activity has come to a standstill in many sectors. For example, the media reported that textile hubs like Tirupur and Surat and the jewelry market have been badly hit – workers are not being paid wages, lay-offs are taking place and sales have come down drastically, with many enterprises forced to shut down.

The biggest impact of this demonetisation policy, however, has been on the informal sector and agriculture. India is an economy where around 45 per cent of the GDP is produced in the informal sector providing employment to 80 per cent of the workforce.

This economy is predominantly cash driven. As a result, the decision of the government to demonetise the currency has hit this sector the hardest.

With money suddenly vanishing from the system, buyers are not being able to purchase from the retail stores, and retailers are not being able to buy from the wholesalers, who in turn are not being able to buy from the farmers.

As a result, the entire supply chain of products like vegetables, fish and other perishable items have been badly hit, with reports in the media indicating that fish markets in West Bengal, vegetable/fruit wholesale market in Delhi, and onion wholesalers’ market in Hyderabad have practically closed down.

It isn’t only the sellers who are suffering but the people who handle the cargo, the transporters, potters, helpers and others as well – all of whom have witnessed joblessness with the markets witnessing zero or negligible business.

Agriculture double hit

The government's demonetisation scheme will significantly hurt India's farmers and ultimately the entire agriculture sector [Image: Archives]

The government’s demonetisation scheme will significantly hurt India’s farmers and ultimately the entire agriculture sector [Image: Archives]

As far as the agriculture sector is concerned, it has been hit on two fronts. This is the time of the year when one harvesting season has just ended (Kharif crop) and another sowing season (Rabi crop) is about to begin.

However, as a result of the loss of cash, both harvesting and sowing is getting hampered because the farmers have been paid the old notes from their sales of their harvest, which are now unusable. With these notes they are not being able to buy seeds and fertilisers or pay wages to the agricultural workers.

On top of this, the RBI has banned the Cooperative Banks from exchanging old notes. Most of the farmers have accounts only with these banks.

RBI’s strange decision means that farmers will now face a liquidity crisis and will be unable to normally carry on their agricultural activities despite having deposits in the banks.

It seems the government is motivated by the idea that poor people do not use Rs 500 or Rs 1000 notes.

This is wrong because according to the national database, current average wages for agricultural labour in rural India is around Rs 250.

So, in order to pay even two days wages, Rs 500 is required. It is obvious that to minimise carrying cost, both the employer and employee is more likely to opt for Rs 500 or Rs 1000 notes to give/take wages.

Agriculture contributes around 15 per cent of GDP in India and employs roughly half of the workforce. The problems in agriculture therefore affect large sections of the Indian population as well as the growth rate of GDP.

On the whole, there is now almost unanimity of views that the government’s demonetisation policy will result in contraction and disruption of the economy.

Former Prime Minister Manmohan Singh, who was also the RBI governor, commented that GDP will contract by 2 percentage points as a result of this policy.

Even international banks and credit rating agencies have cut down their GDP forecasts for India – Goldman Sachs is predicting 1 percentage point decline from its previous projection while Ambit Capital is predicting a decline of 3.5 percentage points.

Whatever might be the exact magnitude of fall in the GDP growth rate, it is undeniable that India’s growth will suffer as a result of this monetary shock deliberately orchestrated by the government.

Why, oh why?

The question is why the government has taken this action.

In response, we are essentially hearing two kinds of views. Firstly, as already stated, this move will result in curbing black money and counterfeit currency and secondly, while there will be short run losses, in the long run people will benefit through a move towards a cash-less economy, higher investment through cheap credit, etc.

The problem is that all these claims of the government are highly problematic.

Firstly, as far as black money is concerned, it is not the case that black money consists only of a stock of currency notes in the denomination of Rs 500 and Rs 1000. Rather, income tax raids this year have recovered black money worth Rs 77 billion ($1.1 billion) out of which only Rs 4.080 billion ($60 million) were held as currency notes and jewelry.

In other words, cash comprised less than 6 per cent of black money.

Secondly, there is a conceptual problem in thinking black money consists of only stock of wealth. Rather, black money must be conceptualized as the result of a set of activities which generate a flow of income, which lies outside the tax net.

While, the demonetisation move writes off a tiny portion of the black money stored as a stock of cash, it does nothing to stop the activities, outside the tax net, which generate black income.

Therefore, demonetisation at best can be thought of as an ‘one off’ effort to liquidate the stock of cash held in black transactions but doing very little to impact the activities generating black money.

It may be that even a fraction of this wealth held in cash will be affected since numerous money laundering processes have been unleashed in the economy to convert illicit wealth into legitimate money.

As far as counterfeit notes are concerned, according to a RBI report, the total proportion of fake notes detected by the banking system in India is only 0.0007 per cent of total currency in circulation.

The actual currency in circulation is around Rs 4 billion ($58.4 million) as estimated by a study conducted by the Indian Statistical Institute in Kolkata.

To eliminate only Rs 400 crore worth of fake currency, the step of the government to withdraw 86 per cent of total currency in circulation is like throwing the baby with the bath water, which in turn has resulted in immense hardship for the common people.

Proper investigation and vigilance is essential on the part of the law-and-order machinery to deal with the problem of fake currency.

The issue of making India a cashless society is superfluous and utopian.

Even in the USA, 40 per cent of all transactions of consumers (by volume) take place through cash, according to data from a 2014 Federal Reserve Bank of San Francisco report.

In such a scenario to imagine that India can be converted to a cashless society, where only 53 per cent have a bank account, is completely unrealistic.

Secondly, a cashless society is a misnomer. What can be achieved is a less-cash society.

The transition to such a society even for advanced economies like USA is said to require seven years. India is very far from attaining the level of financial and digital literacy required to channel bulk of the country’s market transactions through bank transactions.

Instead of decreasing the costs of digital transaction and ensuring better financial inclusion, the clamour for a cashless economy amounts to an onslaught on the informal sector without giving them proper training and time to adapt with changing technology of money and banking.

To achieve such a transition through government diktat also shows an authoritarian attitude and a vision of governance highly tilted against the poor in favour of the rich.

The government’s imagining things

Lastly, the Indian Finance Minister has argued that there will now be a fall in the interest rate and a spurt in economic activity in the country now that banks are sitting on huge deposits and liquidity because of the public depositing the old notes.

This is also an imagination of the government.

Whether an increase in banks’ liquidity will actually lead to higher credit and investment ultimately depends on the demand for credit in the economy.

With the economy moving towards a slowdown, the expectation of investors may not be too favourable, which in turn will not result in an increase in credit and investment.

Over the last year, interest rates have been falling in India – according to the Central Statistics Office, without any substantial increase in investment, with the investment-GDP ratio actually declining.

What has happened on the other hand is that the banks have slashed interest rates on deposits to minimise losses, which in turn has adversely affected ordinary savers.

In short therefore, the policy of demonetisation in India has resulted in a huge monetary and demand shock to the economy, wrecking the lives and livelihoods of significant sections of the population, particularly in the informal and agriculture sector.

The pace at which new currency notes are being printed indicates that full remonetisation of the economy would take at least some months to normalise.

In these circumstances, hardship of the people will continue and might result in permanent damage of the informal sector with very little gain in terms of unearthing black money.

Subhanil Chowdhury is an Indian economist who teaches at the Institute of Development Studies in the eastern Indian city of Kolkata. His research focus is on Globalisation, Labour and Indian Macroeconomy.

The views expressed in this article are the author's own and do not necessarily reflect the publisher's editorial policy.