Demonetization of Indian Currency – A Detailed Study Part 3

In this series called “Demonetization of Indian Currency – A Detailed Study” we shall conduct a detailed examination of the so-called demonetization ( currency-swap) announced by Indian Prime Minister Narendra Modi on 8th Nov 2016, and assess its impact on Indian economy. In the previous parts of this series we had talked about the initial announcement and the reason behind this drastic and sudden economic move. In this part we shall continue to explore Shri S Gurumurthy’s analysis of demonetization in further details.

Part 1: Demonetisation of Indian Currency – Introduction
Part 2: Demonetisation of Indian Currency – Gurumurthy on Demonetisation #1

A Quick Recap

On 8-Nov-2016, the Government of India announced the demonetization of all ₹500 and ₹1,000 banknotes. Prime Minister Narendra Modi in his special address to the nation on the evening of 8th Nov 2016 announced that that Rs 500 and Rs 1000 banknotes would be withdrawn from the financial system “to tackle counterfeiting Indian banknotes, to effectively nullify black money hoarded in cash and curb funding of terrorism with fake notes”. (1) There were stringent oppositions from some small groups of people – notable among them were some Delhi/ foreign based economists, politicians of opposition parties and media personnel. However in general the announcement was greeted with whole-hearted support by most Indians.

Noted economic commentator and black-money crusader Shri Swaminayhan Gurumurthy has provided with facts compelling arguments why demonetisation was the only option available to rescue India from the terrible economic position the previous regimes had pushed her to.

Gurumurthy on Demonetization

The below points are quotes and paraphrases of Shri Gurumurthy’s views on demonetisation.

Countering the Negative Views of International Economists

Demonetisation of Indian Currency - A Detailed Study Part 3 - Foreign Economists on India

Shri Gurumurthy believes that India should stop depending on international economists for opinions. “They don’t understand India. We have our own systems and we must have our solutions. Economists like Paul Krugman don’t think this is the correct thing to do but the people of India say this is the correct thing to do. If they had not believed in this, the country would have been up in flames. But tell me, has there been any skirmish? .. Even Raghuram Rajan could have made a good governor at the Federal Reserve. He understood America, not India. One cannot understand India by reading books and writing thesis. Narendra Modi is not an economist but he understands India. Look how property prices are coming down.”

Potential Impact of Demonetization on Indian Economy

“Out of the total circulation of currency about 16.6 lakh crores, 87 per cent is in Rs 500 and Rs 1,000. How much of this finances genuine economy versus the illicit economy is not very clear.”

“Over and above, the fake currency in circulation that is not counted within this overall figure of 16.6 lakh crores. This directly affects security of India. For instance, 3 per cent of total money deposited in the banking since demonetisation began was in Jammu and Kashmir banks. The extremists had threatened the people not to go and deposit the money. But people queued up in the banks! There has been a sudden drop in unrest – it means this has had a very positive impact in a very sensitive place like Jammu and Kashmir.”

Preventing Terror Funding

“The new currency will eliminate counterfeit currency. The denomination in which counterfeit currency operates is in Rs 500s and Rs 1,000s. The Naxalite funding is through normal currency. According to one estimate, about Rs 50,000 to Rs 60,000 crores of the extremist funding is in the form cash. It will be very difficult for them to deposit – their funding is designed for cash economy. Left extremism will receive a very, very serious setback because of this.”

“A 500 rupee note in the hand of a terrorist is different from the same in anybody else’s hand”

Monetary Surplus of Reserve Bank of India

“According to an estimate by State Bank of India, out of Rs 12 lakh crores in the cash economy, Rs 3 lakh crores may never come back into the system. So, this will be the monetary surplus in the Reserve Bank of India. Out of the Rs 12 lakh crores that comes in, the government should get a substantial tax revenue of about Rs 2 lakh crores. This should have far-reaching consequences on the Indian growth story.”

“If Rs 5 lakh crores is in cash economy, it just stays as Rs 5 lakh crores. But if Rs 5 lakh cores comes into the banking system, because of the fractional reserves basis, this Rs 5 lakh crores can become Rs 20 lakh crores.”

“Let us assume Rs 100 is deposited in a bank. About one quarter of the amount will be invested in government bonds and reserves. The remaining 75 per cent will be available for lending. This 75 per cent gets into the banking system. My estimate is, that at a minimum, the banking system multiplies the money in the system by three or four times. Money creation by banks will increases prosperity. The black or the cash economy therefore is inefficient in using money this way.”

Demonetisation of Indian Currency - A Detailed Study Part 3 - Small Business Bonanza

Benefits to Small Businesses

“Once these kinds of deposits come into the system, there will be an all-round reduction in interest rates. Big industries in India have access to foreign funds and are able to draw money at international rates. It is the small and medium industries that are paying very high rate of interests. The reduction in interest rates will be very good for our economy.”

However Shri Gurumurthy cautions that the initial impact would be on small and medium enterprises. He explains:
“Demonetisation has hit the sector and that is the only way to improve it. Because they are being funded in black cash at 60 per cent or even higher rate of interest. Now that money is coming back into the banking system, the challenge for the government is precisely how to finance the MUDRA sector. May be the government will come out with a couple of lakh crore guarantee to the banks, which enables the latter to finance the small and marginal businesses. Now if these businesses which have been running with money borrowed at 60 per cent get the same at 16 per cent or less, there will be lot less burden on them because much of their energy is now spent on repaying the high cost borrowing, leaving them with little margins. This is crucial considering that we have 58 million non-farming units employing 128 million people. The organised sector employs just 12.8 million. Only four per cent of them are funded by banks, and the balance is funded by the unorganised money.”

“The answer is not to let cash economy to continue but to find an alternative. That is why the Mudra bank was formed but it was opposed by RBI. The government wanted to formalise the informal sector.”

Mainstreaming the Unorganized Scetor

Shri Gurumurthy says that it is not that the unorganized sector is reluctant to join the mainstream Indian economy. Rather it has been the peculiar economic environment in Indian economy that has lead to this scenario. He explains: “It is not as if the unorganized sector does not want to be a part of the banking system. They have not been because banks have not lent money to them. Once those who are a part of the unorganized open accounts and transact officially, the banks will also lend money. It is a dual process. Even without demonetization, it may have happened incrementally but what this does is to have that quantum jump.”

Land Prices Could go down

“Because of the withdrawal of cash from real estate economy, land prices will moderate and moderate, I expect, by 30-40 per cent. This will increase the affordability of housing, most people are not able to afford houses because of high land prices. Construction prices are dependent on commodities, land prices are dependent on the amount of money that chases land.”

Impact of Demonetisation on GDP

“Sound economics suggest that the cash to GDP ratio should be around eight per cent. It is now 12 per cent with 17 lakh crore currency for a GDP valued at 150 lakh crore. Back in 1999, it was only 9.4 per cent. Since then, many have shifted to banking system but still the cash ratio went up because of HDNs. We, at best, require 12 lakh crore in currency and in lower denominations, so that cash remains a flow and does not become stock. Unless some amount of coercive persuasion is put in place, the shift to a formal economy will not happen, either from the supply side or demand side. This is my view.”

According to former Prime Minister of India Manmohan Singh, demonetization could reduce India’s GDP by 2%. To this Shri Gurumurthy replied that the move would have “remained undoable” had it not been done now.

“It could have been easier if they had done it years ago but they didn’t do it. As an economist, Manmohan Singh should have given proper numbers and not a speculative figure. Here is a correction ahead of the crisis. Economists say crisis is inevitable. But this is to avoid crisis and this crisis is deliberate. We can control it, unlike the 2008 crisis (global recession) that was uncontrollable because there was no planning.”

Challenges before the Government on Account of Demonetisation

“The first challenge is to ensure that the non-formal sector gets requisite financial support from the banking system through non-banking and microfinancing agencies, unlike the case thus far when lending has been largely limited to corporates and other organised classes. This paradigm shift in lending, which could make money available to the informal sector at 16 per cent or lower interest vis-a-vis the 60 per cent rate at which they currently borrow, would lead to a sharp spike in employment.

The second is to plug the areas which generate black money. Towards this end, his solution is to provide scope for non-ornament gold to be deposited in banks at zero or nominal interest for a long term period with complete tax immunity, the only way to handle the existing stock of black gold. This could result in gold deposits to the tune of 2,000 to 3,000 tonnes, which could be sold by the banks to the RBI, thereby creating liquidity to fund infrastructure development.

The third step, Gurumurthy feels, is to put a check on benami land purchases, which has pushed up property values even in villages. “Unless these three challenges are met effectively, sooner than later, cash economy is going to come back to haunt us again in a few years,” he cautions. Is the government thinking on these lines? “I can only make as intelligent a guess as you can. But, the Prime Minister has already indicated that more reforms are in the offing so I guess they are on the job,” he said.”

Source:
(1) https://rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=38520
(2) https://swarajyamag.com/insta/why-demonetisation-was-needed-and-how-it-will-greatly-help-the-india-growth-story
(3) http://www.newindianexpress.com/nation/2016/dec/24/note-ban-was-an-inevitable-step-gurumurthy-1552563.html
(4) http://economictimes.indiatimes.com/news/politics-and-nation/demonetisation-necessary-as-upa-never-checked-growth-of-black-money-gurumurthy/articleshow/55948796.cms
(5) http://www.thehindu.com/opinion/op-ed/Not-a-tragedy-but-the-remedy/article16798081.ece

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A Few Last Words

Before making any investment decision, please contact your financial adviser.

I have provided this article for educational purpose only.

I hope you found this article on Demonetisation of Indian Currency – A Detailed Study Part 3 useful. If you have something to add please leave a comment in the post. Please feel free to contact me.

Subhodeep Mukhopadhyay

I am a Management Consultant in the Education Sector. In my previous corporate career, I have worked in Banking, Private Equity and Software industry. I am an MBA in Finance/ Computer Engineer and enjoy doing equity research and financial analysis in my free time.

4 thoughts on “Demonetization of Indian Currency – A Detailed Study Part 3

  • February 13, 2017 at 11:27 am
    Permalink

    Yes, for far too long we have been looking up to the foreign economists for suggestions and solutions for our economic woes. Gurumurthy’s views are right on the dot – we need our solutions! I am amazed at the intuitive understanding of the majority of Indian masses as to why demonetisation was the right move.

    Reply
    • March 4, 2017 at 12:13 am
      Permalink

      True. Except for politicians, and in some militant states like West Bengal etc, general people did not seem to mind it that much.

      Reply
  • February 22, 2017 at 3:57 pm
    Permalink

    The article is detailed and very well written, however the topic of demonetisation deserves to be explored even more especially in the context of how it could be the ultimate blow to swinging the entire economy towards a cashless one.

    Reply

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