Manmohan Singh was right on demonetisation: Note ban reduced real economic activity, shows NBER paper

In November, 2016, when former prime minister Manmohan Singh predicted that country’s gross domestic product (GDP) could fall by about 2 percent on account ofdemonetisation announced by his successor Narendra Modi, it kicked off a political storm. “My own feeling is that the national income, that is the GDP, can decline by about 2 percent as a result of what has been done,” Singh had said in Parliament then.

Impact of demonetisation on the economy versus its perceived gains have been a subject of intense debate since 8 November, 2016. Now, a working paper from National Bureau of Economic Research (NBER) titled as ‘Cash and the economy: Evidence from India’s demonetisation’ authored by Gabriel Chodorow-Reich, Gita Gopinath, Prachi Mishra, and Abhinav Narayanan tells us that demonetisation indeed lowered the GDP (gross domestic product (GDP) growth by at least 2 percent in the near-term post demonetisation. "Our results imply demonetisation lowered the growth rate of economic activity by at least 2 percentage point in the quarter of demonetisation,” the paper says.

Representational image.

Representational image.

The economists said their study suggested a decline in nightlights-based economic activity and of employment of 3 percentage point or more in November and December of 2016, which translates into a decline in the quarterly growth rate of 2 percentage point or more. Nightlight intensity refers to low-light imaging data collected by satellite and filtered to measure the quantity of artificial (i.e. human-generated) light in an area.

Such data have been used to augment official measures of output and output growth and to generate estimates for areas or periods where official data are unavailable, it said. This showed a contraction in economic activities in the post noteban period. Based on their research, the authors concluded that “while the cashless limit may appropriately describe economies with well developed financial markets, in modern India cash continues to serve an essential role in facilitating economic activity.”

Modi announced his decision to invalidate Rs 500 and Rs 1,000 notes on 8 November, 2016 in search of black money, fake currency and as a shock treatment to cash-based corruption. This exercise, which was executed keeping the country’s central bank on the sidelines, instantly sucked out 86 percent of the currency in circulation from India’s cash-intensive economy.

The move hit the informal economy particularly hard since cash played a dominant role in making the daily transactions seamless. Supply chains were broken and small shops were shut. The impact on unemployment and rural economy became more visible in the period that followed. The speculated gains of the note ban - widening taxpayer base and push for digitalisation - are much less compared to the pain the exercise inflicted upon the economy. The government deployed its top ministers and bureaucrats (including current RBI governor, Shaktikanta Das, to defend the scheme and counter the critics.

The NBER paper throws more interesting details on demoentisation. It says while households were forced to deposit cash into banks, they could freely access these funds in the form of cheques, debit cards or credit cards.

"The Indian demonetisation episode speaks directly to the importance of cash," the report said. The paper then gives illustrations on why cash remained king in the Indian economy citing the way households handled their income and expenditure. Overall, it finds that demonetisation reduced real economic activity.

The research found that bank deposits increased and credit contracted in areas experiencing more severe demonetisation. “The effect on deposits appears short-lived while the effect on credit may be more persistent. Because banks have access to internal credit markets and banks in more-demonetized districts experienced faster deposit growth, we can interpret the contraction in lending in those districts as due to lower borrower demand for credit,” the paper said.

The paper, however, ends with a disclaimer that the emphasis was to focus on the near-term impact of demonetisation. "There may be longer term advantages from demonetisation that arise from improvements in tax collections and in a shift to savings in financial instruments and non-cash payment mechanisms. Evaluating these long-term consequences requires waiting for more data and an empirical strategy suited to the study of longer term effects,” it said.

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Updated Date: Dec 20, 2018 11:19:38 IST

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