Demonetisation in light and shade

The economic activity will see a significant dip for next 9-12 months because of this shock.
Demonetisation in light and shade
File Photo

On November 8, 2016 at 8.p.m. when people were busy in their routine schedule, PM Modi suddenly announced demonetisation of Rs 500 & Rs 1000 currency notes.  The word spread like wildfire and harassed people started queuing for hours at nearby ATMs to take out Rs 100 currency notes  as it was announced that ATMs will stop functioning from midnight for 2-3 days and 9th November will be a bank holiday for carrying out public transactions. From the last few weeks, the long queues outside banks, ATMs and post offices to exchange, deposit or withdraw money are seen.  Even it came as a nightmare to banks and there was chaos and confusion because nobody in his wildest dreams would have ever thought that the Rs 500/1000 currency notes will lose its legality. Now the question arises why demonetisation? Was it for the first time particular currency notes in circulation were demonetized? Firstly, demonetisation is withdrawal of a particular form of currency from circulation or general usage. Majority of people would be unaware of the fact that it was not for the first time, currency in circulation was demonetized in India. Infact, demonetisation dates back to January 1946 when Rs 1000 and Rs 10,000 bank notes were demonetized to curb unaccounted money. These high demonetized notes were reintroduced in 1954 and then again demonetized in January 1978. Now after a gap of 38 years, the high denomination notes were again demonetized on November 8, 2016.

EFFECTS OF demonetisation

demonetisation by itself has its merits and demerits but the sudden nature of this execution has created more negative externalities than positive outcomes. 


LOW INFLATION AND LOWER FISCAL DEFICIT: India is the only country in the world where circulation of currency is 12% of Gross Domestic Product (GDP) while as in developed countries, currency in circulation does not exceed 4% of total GDP. This excess currency in circulation result in high inflation and high fiscal deficit. Thus it was the need of the hour to suck excess currency from system in order to bring down inflation and contain fiscal deficit. It would be pertinent to mention here that out of the Rs 14 lac crore worth of Rs 500 and Rs 1000 notes that have been scrapped, rougly Rs 3 lac crore are not likely to be exchanged for new notes ever. This unaccounted money or disappeared black money will be treated as profit to the RBI and would be transferred to the central government as dividend. This of course depends on the estimation being correct. It would be pertinent to mention here that the total cash in circulation in the Indian economy is roughly Rs 18 trillion meaning that the domenitization will reduce the money supply by 16 or 17 %. The benefit would be lower inflation and low fiscal deficit.

Low Interest Rates: demonetisation will reduce interest rates as there would be more liquidity in the system. Although interest rates on deposits has already been reduced by many banks post demonetisation but interest rates on loans are yet to be reduced by banks. Though it is not a great news for those parking their money in banks but lending rates are likely to follow suit in a few weeks in order to provide sluggish credit expansion a much needed boost. In last 2-3 weeks, the banks have witnessed huge inflow of deposits but demand for credit has shown a significant dip. Therefore it becomes necessary to bring down the lending rates. Furthermore, it is also widely presumed that central bank would reduce repo rate by atleast 50-70 basis points in the next monetary policy which would directly be passed by banks to its customers. Majority of the economists are of the view that post demonetisation, interest rates would be brought down by 300-350 basis points in next 2-3 years. This would provide a sigh of relief to common people.

Taxation: There would be enormous increase in the number of first time tax payers. As it has been time and again clearly stated that abnormal increase in deposits would attract higher tax plus penalty. The latest notification states that higher abnormal deposits would attract 60% tax and 25 or 50 % of deposits will have a lock in period of 4 years. Although tax exemption limit of Rs 2.5 lacs has been prescribed but it need to be matched with his income pattern , otherwise it would attract tax plus applicable penality. As a result, some money would indeed be taxed and it would not have been possible without the demonetisation initiative which in other words means that the budget deficit will be smaller and it in turn will bring down the interest rates and inflation.

Digitalization of the financial economy: Because of the shock given to the system, demonetisation will accelerate the digitization of the financial economy and financial inclusion. The basic idea behind demonetisation is to create an environment of cashless economy. The people will slowly and steadily adapt themselves to unified payment interface to make online payments by virtue of their smart phones. 

NEGATIVE EFFECTS: The economic activity will see a significant dip for next 9-12 months because of this shock.

EFFECT ON GDP: The impact is going to be clearly negative in the short run. Most of the economists are of the view that GDP of the country will shrink by atleast 2% due to reduction in over-all spending. 

EFFECT ON DIFFERENT SECTORS OF ECONOMY: The indian economy broadly consists of 21 sectors. The effect of demonetisation varies from one sector to another. The cash based sectors like reality and jewellery will have severe liquidity issues. The reality prices are expected to fall by atleast 25-30% while as the demand for gems and jewellery is expected to decline in next 2-3 quarters as large potion of inventory of this sector remains unaccounted and big purchases are done via cash only. In the same manner, private educational institutions will be hit hard as donations upto 40-50 % are taken in cash only. The liquidity crunch will have short term disruptions in agriculture and allied activities as most of our rural economy is based on cash only. Other sectors which will be mildy effected include small traders, households, professionals, retail outlets etc. 


To sum up, India is not the only country that has tried demonetisation. Prior to India, several countries like Ghana (1982), Nigeria (1984), North Korea (2010) etc tried demonetisation but their economy collapsed. Although largely perceived as a sudden announcement but  I feel that demonetisation was on cards because various initiatives were undertaken by central government to curb unaccounted money. Firstly the government re-negotiated double taxation treaties with Mauritius and Cyprus. Then bankruptcy code  was brought in. After this, provision under Income Tax was made to disclose black money and then voluntary disclosure income scheme was introduced. Finally benami transaction rule was brought in. Although the objective of demonetisation  is to curb black money and prevent growth of forfeiture currency notes, its implemenation and the manner in which it was introduced without any proper planning has raised many eyebrows which in turn has resulted in currency crunch because Rs 100 and Rs 2000 currency notes are not circulated and deposited back to the banking system. Thus in a way the initiative taken by PM Modi to curb black money resembles more or less to the "Great Sparrow Compaign"  of China. In 1958, Mao Zedong ordered that all sparrows in the country be killed as the country has the potential to grow without pests like sparrows. The result was the death of 45 million people. Only time will tell whether demonetisation will prove disastrous to economy or a stepping stone to development. 

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