Demonetisation: India's GDP may not fall much as benefits to outweigh disadvantages in long term

The consequences of the bombshell dropped by Prime Minister Modi on 8 November is gradually sinking into the psyche of the Indian populace. Financial Analysts and economists are working overtime estimating the effect of this move on the GDP. The middle class especially the salaried are vicariously elated as they feel that the playing ground has now been leveled. They believe that justice has now been done as the income tax deducted from their salaries for long, is now compensated in one stroke by the black money lost by business class. Let us analyse the short term and long term impacts of the demonetisation strategy on the GDP, without taking sides.

In the short term

There is no doubt that the rate of growth of GDP in the near term will be affected. Around 80 percent of our GDP is contributed by small businesses and demonetisation has affected the liquidity of these businesses in the short term and will remain impacted till all the abrogated notes are replaced.

 Demonetisation: Indias GDP may not fall much as benefits to outweigh disadvantages in long term

Reuters

Economic history shows that the world moved from the gold standard to other standards like the Minimum or Proportional Reserve system as the earth did not hold enough gold to sustain the growing economies in need of a medium of exchange. The advent of currency notes satiated the pangs of liquidity. Liquidity therefore is an important factor that affects the GDP.

However the government is making efforts not only to pump in more money but also spread it across the length and breadth of the country. With this, the apprehensions of those who are already in possession of smaller denominations and the new notes will be allayed and the velocity of money will increase. This should restore the liquidity to the original levels in about 4 to 5 months time.

It is estimated that 20 percent of the GDP is contributed by black money, out of which the cash component is around 4-5 percent and the remaining contributions coming from benami properties, gold and other asset classes. If we believe these statistics then the impact on GDP also will be limited. One can therefore conclude that the impact on GDP will be limited and for a shorter duration.

In the long term

The long term impact is more qualitative rather than quantitative. In the long term, the benefits outweigh the disadvantages and provide a remunerative return for the costs incurred. It is difficult to change the psyche of an entire population. However, in the long run, this measure will impel a large percentage of the population to become ethical and transparent. If honesty really pays then the peer effect or the demonstration effect of being ethical will bring more people into this fold.

Then again a large number of people will shed their inhibitions in embracing a digital payment system and hopefully this will become a norm rather than an exception. When these two characteristics begin to take shape benefits to the economy will accrue in the form of an increased GDP.

There is however one long-term disadvantage in this strategy of demonetisation which I can glean. The currency of a country must command the trust of not only the domestic population but also globally. A sudden move like the present one will create uncertainty in the minds of the investors, especially global investors who abhor uncertainty. I would like to draw a comparison, though unfair, with the US Dollar.

Even in the worst of times the world did not lose faith in the greenback which says a lot about the US economy. To reach this stage we must curb our tendency to make swift, sudden and radical changes which catches the world on the wrong foot. Repeated shocks like this will affect foreign investment which in turn will impact the rate of growth of GDP.

The success of this move depends on the amount of impounded currency which will be exchanged or deposited with the banks. The government expects that only around 80 percent of the impounded currency will be returned and the remaining forfeited by the black money holders. If the amount of currency returned or exchanged is in the vicinity of 93-95 percent then the gamble of the government would backfire, though in such an event the effect on GDP would be minimal.

The author is a professor, faculty finance, with Welingkar Institute of Management Development and Research, Bengaluru.

Updated Date: Dec 09, 2016 16:03:31 IST