Demonetization demystified: A 'Hormegeddon moment' for Indian economy

A fortnight has passed since 8/11, when PM Modi announced the 'Demonetization' of Rs.500/1000 currency notes, a step that has been hailed by many as a 'bold initiative' and 'catastrophic disaster' by others. While I fully support the PM's crusade against black money, corruption and counterfeit currency, I would like to analyse the issue of 'demonetization' from the perspective of an Economist. "Hormegeddon" is a term coined by entrepreneur and New York Times bestselling author Bill Bonner to describe 'How too much of a good thing leads to disaster'.

Demonetization is the act of stripping a currency unit of its status as legal tender. In order to understand the effects of demonetization let us have a peep into history. Demonetization has been tried by several countries in the past to meet the under noted objectives:

• To take out of circulation higher/ lower value notes that have become redundant
• To reduce Govt. debt and reduce inflation
• To remove counterfeit notes in circulation
• To curb parallel economy and illegal trade

In 1969, Richard Nixon, the then United States president, had, in one go, demonetized $10,000 and $1,000 bills. He kept only $100 as legal tender, which achieved its stated objective. But demonetization attempts by Ghana in 1982 and Nigeria in 1984 failed miserably as these debt ridden economies collapsed after demonetization. In 1987, Myanmar’s military invalidated around 80% value of money to curb black market. The decision led to economic disruption which in turn led to mass protests that killed many people. The demonetization that happened in North Korea in 2010 left people with no food and shelter. Mikhail Gorbachev ordered to withdrew large-ruble bills from circulation to take over the black market. The move didn’t go well with the citizens which resulted into a coup attempt which brought down his authority and the led to Soviet breakup. 

Several countries in the past have taken up demonetization drive. but those exercises were too small in nature. India also attempted demonetization in 1978 under PM Morarji Desai when Rs.1000/5000/10000 notes were banned. However, at that time the notes banned formed a minuscule 3% of the total currency in circulation. The present demonetization drive in India is unprecedented and biggest in the monetary history of modern world, as it attempts to take 86% of the issued currency out of circulation. The most acceptable argument in favour of the recent move seems to be a strike against counterfeit notes which have been widely used for terrorist funding. As far as black money is concerned about 97% of the black money generated in India is parked in foreign accounts, real estate and precious metals (gold & bullion), and only 3% may be held in the now banned currency notes. As per RBI estimates out of total currency notes issued worth Rs.1754000 crores, 86% are in denominations of Rs.500/1000.

The immediate likely advantages of this move are:

• A size able curb on Hawala trade from across the border, a big blow to terror funding in India
• A huge surge in liquidity for the banking system, paving the way for lowering of lending rates
• A one time windfall gain of around Rs.3,00,000 crore for the Govt. (in the shape of notes not getting deposited in the banking system), leading to lowering of Govt. fiscal deficit.
• A drastic fall in inflation due to scarcity of money.

Now let us analyse the disadvantages of this move:

India has been billed as the fastest growing economy in 2016-17, which resulted in it getting the status of the most favoured destination for foreign investment. Demonetization will lead to a major dent on our growth prospects leading to a catastrophic effect on future investments in India. The major ill effects are listed below:

• India's GDP is expected to shrink by almost 50% during the second half of fiscal 2016-17. Our GDP estimates for the whole year would be revised downwards to 5-5.5%.
• Indian economy adds approx. 1.2 crore people to the job market every year. With the shrinkage of economic activity most of these people would add to the unemployment stream, leading to widespread discontent.
• The capacity utilisation of the Corporate sector which is already at a low of around 63% is likely to dip further, leading to a fall in turnover and employment generation.
• The likelihood of small business sector taking a major hit are very high. This may lead to closure of several businesses leading to widespread unemployment and higher NPAs for banking sector.
• The shoddy implementation of the scheme is already adding to the woes of the underprivileged sections of the society, especially the daily wage earners.
• The political deadlock over the issue is causing delay over several important legislation, like GST, which is likely to get postponed by one year. 
• The cost of replacement of 86% of the currency is going to be pretty high, although RBI has not given any figures yet.

How far the Govt. is capable to cope up with these challenges will determine the success or failure of this exercise, till such time the patience of millions of honest/ law abiding citizens of our country shall be continuously put to test.