Economic and Social Impact of Demonetization in India

The prime-minister Mr Modi told the nation ’no more cash’,
he made all the money disappear, in a flash.
They had looted, they had plundered,
they had torn the country asunder,
and all the corrupt politicians ended up in the trash.

On the 9th of November 2016, Mr. Narendra Modi, the Prime Minister of India announced a series of measures combating corruption and black money in India. In one swift move, Mr. Modi removed the two largest bills in circulation amounting resulting in decrease of 86% or INR 13.62 trillion (USD 197 billion) of the total value of INR 15.84 trillion (USD 230 billion) .

Black money broadly means unaccounted or undisclosed income and assets not reported for tax purposes, without reference to its origin (whether legal or illegal), and 'black economy' to denote the sum total of incomes/assets as well as activities that are not accounted for. While in developed countries in North America and Europe black money is generated primarily through illegal activities,  in the developing countries in Asia and Africa, generation of black money is from all conceivable sources - corruption and siphoning of public resources, trade-based black money due to non- reporting of incomes or profits and inflation of expenses, in addition to a host of criminal activities. 

The rationale behind demonetization

  1. Financial transactions for transfer of assets are conducted partly in cash outside the purview of the legal system. For example, when buying a property for INR 1M, the transaction might be registered for INR 500,000 on which taxes are paid while the other INR 500,000 paid in cash, is outside the purview of the legal system.
  2. Local businesses generate black money by suppressing receipts and inflating expenditure. Businesses inflate expenses through fake or inflated invoices. Goods and services are invoiced multiple times. Corporations practice transfer mispricing by under invoicing their exports or over invoicing their imports.
  3. This wealth is used to subvert democracy by paying cash to voters to elect a certain political party to power. Once in power, the party recoups their investment at the expense of economic development. The two major national parties claim to have incomes of merely Rs 500 crore and Rs 200 crore. But this isn't "even a fraction" of their expenses, when they spend between INR 100 billion and INR 150 billion annually on election expenses. 
  4. The bureaucracy is complicit in corruption including bribery and theft by those holding public office - such as by grant of business, bribes to alter land use or to regularize unauthorized construction, leakages from government social spending programmes, speed money to circumvent or fast-track procedures, black marketing of price controlled services. Reducing the amount of cash in circulation, limits moneys that can be paid as a bribes.
  5. To eliminate counterfeit currency
  6. Limit benami (proxy) transactions. Transactions are made by proxies on behalf of another person by merely lending their name while control vests with the person who actually makes the purchase and is the beneficial owner.

Impact on society

All this comes at a cost of decline in GDP estimated at two percentage points for up to two quarters due to reduction in consumption brought upon by a shortage of cash. This affects the lower classes disproportionately, these are the ones without savings and other reserves to fall back on. While the opposition has been moderate so far, the longer the hardship continues, the lesser the people will tolerate the suffering. 

These steps have been taken in the move towards cashless economy. A cashless economy with an audit trail  and increased transparency will directly result in reduction of corruption, elimination black markets, accountability  and better governance.  A cashless society will enable sharing India's economic growth with the poor by ensuring that benefits from governmental programs flow to the recipients directly bypassing the bureaucrats and eliminating leakage. There is likely to be an increase in government spending programs over the next couple of years before the next general elections in Q2, 2019.  

The number of Indians with bank accounts has surged to 1.17 billion with 347 million savings bank accounts added since 2013. The next big challenge is to get the rural people to actively use their bank accounts 40% of which are dormant. The government might use the moneys collected by the demonetization to inject cash directly into the accounts of the poor. An injection of INR 10,000 into 500M accounts would result in an expenditure of INR 5 trillion which is still below the amount demonetized.

Impact on investments and capital

Mobile payments like PayTM and online commerce site like Flipkart and Amazon will be big beneficiaries of this move. Expect to see additional investment in the Fintech and E-Commerce. Wealth will be hoarded in non-monetary assets like gold and decentralized virtual currencies like bitcoins which exist outside the purview of governments. 

This is one of the defining moments in India’s economic development. This will be looked upon as the time when the country broke free of the shackles of corruption holding it back and boldly went where none had gone before.