Why note ban may lead to huge drop in economy

About Rs 15 lakh crore of high-value notes were scrapped, against which RBI has managed to supply roughly Rs 4 lakh crore worth of notes in the market so far, Anup Roy/Business Standard reports from Mumbai.

IMAGE: The direct impact of demonetisation is wastage of time and productivity as people stood in queues outside cash vending machines and banks. Photograph: Sahil Salvi

Even if India manages to sail through the current financial year with a minor dent in its economic growth rate, financial year 2017-18 could witness big downturn due to the demonetisation drive, warned Kaushik Basu, former chief economist of the World Bank and former chief economic advisor to the government of India.

The direct impact of demonetisation has been obvious, which is wastage of time and productivity as people stood in queues outside cash vending machines and banks. But, the second and third round of impacts, that will come into play a few months down the line, could be deeply unsettling and even cause deflation, warned Basu in a speech at Indian Institute of Technology, Bombay.

“In the economy, money works like blood. You don’t realise that blood is flowing inside you, but you realise it when things go wrong. Similarly, money is blood for the economy. Because of this huge jamming of money flow, the government has to soon step in at every step to compensate for the productivity loss and to maintain order. That is interfering with the ‘invisible hand’ or the ‘laws of markets’ (which is unalterable),” he said in his speech titled The economics of corruption, black money and demonetisation.

“Money is such a huge animal that you better don’t disturb it. Whoever tried to do that and alter the laws of markets have created huge turmoil for the people even if the intentions were always noble,” said Basu.

About Rs 15 lakh crore of high-value notes were scrapped, against which RBI has managed to supply roughly Rs 4 lakh crore worth of notes in the market so far.

Even if the central bank manages to scale up this supply to Rs 6 lakh crore soon, there would be a huge gap that would still be demanded in the system. This will shrink demand in the economy, bring downturn in the services sectors and tourism, lead to outflows of foreign investments, and may severely hit the rural economy and bring food security problem.

About 98 per cent of India’s total transaction takes place in cash and giving a shock to it has not been good economics, he said.

“If the money stock gets scorched and then the Reserve Bank start putting helicopter money (increasing money supply through various means), and I do believe RBI and the government eventually will have to do it, it will have its own ramification,” Basu warned.

For example, while money will be taken away from everybody, including poor people who don’t have bank accounts (47 per cent of the adult population), when the money is pumped back, the reach will not be in the same proportion. This will create imbalance among two sets of people.

One that get ready access to new cash and those who don’t. Those with access will have their own consumption pattern that won’t match those of the poor in rural areas, who could remain excluded from getting the cash back.

“The change in consumption pattern would mean that producers will get confused as to what to produce. Prices of some commodity will fall, whereas that of others will increase. I think farmers are going to lose out in a big way. This will hit the economy in uncertain ways and productivity activity will suffer,” Basu said.

Basu roughly agrees with RBI’s estimate for 2016-17 that the economy will probably grow at 7.1 per cent, from 7.6 per cent estimated earlier.

“But the next year will be much worse, I believe,” Basu said, adding, “I am expecting a huge drop in economy.”

Basu proposed if it was possible, government should make the old Rs 500 notes as valid legal tender, instead of scrapping it altogether. It will damage the image, yes, but the economy could still be repaired, he argued.

Otherwise, the Reserve Bank will have to do some “brilliant and clever economic engineering” to tide over the situation in the next year.

Even as the government is enjoying political and people support on the demonetisation drive, it would unlikely last long as the agriculture sector and rural productivity drop, Basu said.

According to Basu, the demonetisation exercise managed to get rid of a tiny fraction of black money stashed in cash but there will be immediately buildup of new set of black money in the new Rs 2,000  notes.

“It’s one-time clean-up of the existing black money in cash and for that you have given a jolt to 86 per cent of the total currency,” Basu said in his speech.

Eventually every country will have to move to the digital platform. Even central banks will have to trade through cryptocurrencies like Bitcoin, but that cannot happen suddenly.

“Even in a country like US, you need to give 10-15 years to do that. India just cannot do that overnight without causing huge hardship,” Basu said in his speech.