Demonetisation Will Likely Lead to a Protracted Economic Slowdown

The impact of the contractionary demand shock triggered by the note ban will gradually radiate from cash-intensive activities to virtually every sector of the economy.

In most emerging economies, an important driver of GDP growth is investment demand. In India, private sector investment has been sluggish for consecutive quarters over the last two years. The principal driver of GDP growth in India in recent times has been private consumption demand, which contributes 60% to the GDP.
The announcement by the government on November 8 to ban the Rs 500 and Rs 1000 currency notes is a monetary contraction that will translate into a massive negative shock for consumption demand. As more and more firms start feeling the pressure of declining demand, investment will get adversely affected. The combination of a slowdown in consumption and investment may result in a fall in GDP growth rate lasting beyond two quarters.
GDP growth rate was estimated at 7.3% in the July-September quarter of 2016-17. The marginal increase from 7.1% in the April-June quarter was primarily driven by agriculture, construction and the services sector. Ironically, these sectors are now likely to bear the brunt of the currency-ban shock. Year-on-year manufacturing growth rate has declined from 9.1% in the previous quarter to 7.1%. In the July-September quarter investment demand contracted by 5.6%, resulting in a large negative contribution to the GDP.
In general, private sector activity in the economy has been weak in the recent quarters. The state of the economy prior to the announcement of the currency ban is essential because it highlights the structural weaknesses in the economy that may worsen as a result of this shock and aggravate the economic slowdown.

Cash in the economy
Estimates suggest that the reduction in GDP could be somewhere between ten to 330 basis points. Given the widespread reliance on cash, the actual impact could be bigger. The following highlight the dependence of the Indian economy on cash:

• India is amongst the most cash-intensive economies in the world with a cash-GDP ratio of 12%. The same ratio in its peer economies such as Brazil and South Korea is one-third of India;
• Cash in circulation to private consumption ratio in India is 20%, and
• Card transactions account for 4% of the personal consumption expenditure.

In such a cash-dependent economy, all of a sudden around 86% of the cash supply has been rendered useless. This has effectively imposed a tight constraint on real economic activity. This constraint will initially be felt most acutely in the cash-intensive sectors such as agriculture, construction, gems and jewellery, textile, trade, transportation and real estate as well as in the activities in the vast informal sector of the country.
Beyond the initial impact, the shock from demonetisation is likely to set off a domino effect that will impinge on activities far removed from the cash-intensive sectors. This impact may result in a protracted economic slowdown going beyond the current financial year.
It is likely that firms and households will innovate in an attempt to get around the cash constraint. Formal financial services will provide support to those who have access to them. Firms in the retail business that utilise the formal financial services will face a rise in demand as consumers shift from the cash economy to the digital economy. These innovations will dampen the effects of the shock to some extent, however, they cannot act as much of a cushion in an economy which is so overwhelmingly dependent on cash. So, even if the share of digital transactions doubles, it would still represent only a small portion of the transactions in the economy.
Will the economy rebound after a short period of distress?
While some initial data has already started signalling a slowdown, experts opine that the slowdown in the next two quarters would be temporary and would be followed by a quick and strong period of rebound. They conjecture that as the expected benefits of the currency ban start kicking in and as the cash supply in the economy gets replenished, normalcy will be restored.
We, however, argue that reviving the real economy and getting it back on a high growth track could be a much more difficult and time-consuming process.
A continued shortage of cash is already forcing consumers to postpone their purchases, especially of non-essential goods and services. There have been reports of a decline in footfall in shopping malls and retail outlets have reported a sharp drop in sales over the last month.
In an environment of uncertainty, it is natural for economic agents to behave cautiously. Two kinds of currency have now emerged – cash and deposits. While people are able to convert cash into deposits, going the other way round is more difficult due to the administrative restrictions imposed by the government on withdrawals along with the unavailability of sufficient usable banknotes even a month after the demonetisation.
Given the widespread uncertainty about more restrictive withdrawal limits being imposed and about the time taken by banks and ATMs to disburse the new notes, it is likely that households will hoard whatever cash they are able to obtain instead of spending it. This tendency to build up precautionary savings could continue for a while even after the money supply is restored. This will exert an additional downward pressure on consumption demand.
The quantity theory of money states that there is a direct relationship between the quantity of money in an economy and the level of prices of goods and services sold, i.e. MV=PY, where M is the money supply, V is the velocity of circulation of money, P is the price level and Y denotes output.
The currency ban has reduced the money supply drastically. As people hold back consumption and hoard cash, the velocity of circulation will fall. This means both P and Y have to decrease commensurately in order to restore equilibrium in the system. Estimates suggest that it may take six to eight months for the new currency notes to fully come back into circulation. The time taken to restore money supply may reduce the velocity of circulation for an even longer period, thereby resulting in a protracted GDP contraction.
Long-term impact
A stable, sophisticated economy is one where economic agents are able to take risks as well as make long-term plans. This includes private businesses, financial investors and households. A major shock like the currency ban disrupts the overall stability of the economy. The continuous change of rules almost on a daily basis further adds to the uncertainty. Since November 8, the government has changed rules related to the currency ban over 20 times and the RBI has released more than 15 sets of frequently asked questions to clarify this change in rules. These actions create an environment of unpredictability and in such an environment, firms and households hold back their investment and consumption plans. This further puts a brake on real economic activity and it is likely that even after the currency notes are back in circulation, the brakes stay on or are only gradually lifted.
One segment of the real economy that could be severely hit by demonetisation is the medium, small and micro enterprises (MSME) sector. This sector plays a pivotal role in the economy, contributing about 8% to the GDP, 45% to the total manufacturing output and 40% to the total exports from the country. Given the reliance of the sector on cash, especially for the small and micro enterprises, and the cost of compliance with regulations in the formal sector, some of these firms may not remain viable or solvent in the changed environment.
Some of these firms that were already struggling to meet their interest payments amidst the business cycle downturn over the past few years, may now tip over and become bankrupt as a result of the liquidity crunch. Once businesses start failing, valuable organisational capital gets eroded. Irrespective of how quickly money is put back into circulation again, some of these losses could be irreversible, thereby inflicting long-lasting damage on the growth of this sector.
The initial contractionary effect on the sale of goods and services will negatively impact business investment at a time when private sector investment is already sluggish.
The revival of private sector investment requires a sustained flow of credit. Bank credit to the corporate sector has remained tepid over the last few months. Analysis shows that despite banks receiving a large volume of deposits since November 8, their ability to make fresh loans remains limited. In addition to this, if a large number of firms in the MSME sector default on their loans, this will exacerbate the existing non-performing asset (NPA) problem of the banks. This, in turn, may further affect their capacity to extend credit given their already precarious capital adequacy position. These developments coupled with the heightened macroeconomic instability triggered by the currency ban do not augur well for the private investment scenario.
Another long-term impact of the shock may result from the negative wealth effect on consumption demand. For example, the real estate sector is likely to take a severe hit due to the currency ban since a large percentage of the transactions in this sector have traditionally been cash-based. As real estate prices start falling due to the liquidity crunch, people who had invested their savings in real estate will experience wealth erosion and may cut back on future consumption plans. This is likely to impose a lingering effect on aggregate demand.
The long lasting nature of the economic slowdown may also result from the ripple effects spreading across the entire real economy. It is well understood by now that the large informal sector accounting for 80% of the country’s employment and 45% of the GDP will be disproportionately affected by the liquidity crunch because of its inherent dependence on cash. While the share of the informal sector is estimated at ‘only’ 45%, this hardly means that majority of the economy will be insulated from the shock. A reason for that is that firms are interlinked in production. The production and sale of a good require a long chain of transactions, many of which involve cash.
If just one link in this chain breaks down, there will be problems. For example, one tends to imagine that exports will not be affected, because exports generally involve bank transactions and not cash. But that is only true at the final stage. At the earlier stages, cash can be quite important, for example, in the textile sector where many of the activities are carried out in small workshops and are cash-dependent. If a large number of these workshops start shutting down because of liquidity constraints and a decline in sales revenues, the entire supply chain in the textile sector will get disrupted. Even if the new notes come back into circulation in a few months’ time, this kind of real economic disruption may last much longer.
All these point to the possibility that once GDP growth starts falling, it may take several quarters before the economy gets back on track again.
Conclusion
The impact of the contractionary demand shock triggered by the November 8 currency ban will gradually radiate from cash-intensive activities to virtually every sector of the economy. This will lower the GDP growth. The resurgence in growth may prove to be a challenge and may take longer than expected in an already sluggish investment scenario. Given the magnitude of the shock and the channels through which economic activity may get disrupted for close to a year, if not more, it is surprising that the RBI estimated the impact on growth to be limited and transitory as announced in its recent monetary policy review meeting.
It may be worthwhile to ask, had the currency ban announcement not been made, how would the economy have progressed? Before November 8, India’s GDP was growing roughly at 7%, primarily boosted by growth in consumption expenditure. Private investment activity has been weak. Banks have been saddled with NPAs and till now no well-defined policy measure has been devised to resolve the problem and boost credit off-take in the economy. Demand for corporate credit has been stagnant for several quarters and an overleveraged corporate sector has been refraining from initiating new investment projects.
During this time, the singular objective of the government should have been to adopt structural reforms to stimulate GDP and achieve a high and sustainable growth rate. Generating jobs to absorb the demographic dividend while it lasts should have been another policy priority. Instead of prioritising these objectives, the government announced a measure that has in fact dealt a severe negative blow to the overall economy.
The associated policy uncertainty is contributing to macroeconomic instability. Arguably, this is the last thing that was needed now given the pervasive weakness in the credit and investment climate. Policymaking over the next couple of quarters is likely to get hijacked by this single event in order to ameliorate a potential economic damage. All this is very costly both in terms of the time spent and the resources used up in first delivering the shock and then in restoring normalcy.
The longer the time taken to normalise the situation, the deeper will be the damage inflicted upon the real economy, and some of the damage caused may end up being irreversible. Perhaps a year later it would be worthwhile to ask whether the costs in terms of a protracted economic slowdown were worth the benefits arising from this move.