Wednesday, November 16, 2016

Demonetization Economics

Black money & Demonetization

     Demonetization of 500 & 1000 notes was a risky move given that corporate sector has still not fully recovered, international headwinds remain strong and private investment remains below par. Demonetization of 86% of the total currency, compared to <2% in the previous such episode in India, can be viewed as an incredibly bold decision or a gamble, depending on your point of view. It must however be analyzed in the context of other actions against black money taken by the govt. 
1) Black money abroad: Black money bill, cooperation with US, EU who have introduced corruption & tax evasion laws, International co-operation on Tax havens.
 (2) Domestic Reforms: Transparent auction systems for natural resources (telecom spectrum, coal, minerals); Real Estate Regulation Bill, GST, CIT reform (25% by 2019), measure to ease payment of PIT, mobile wallets, Aadhar & bank acts for poor (Jan Dhan), Rupay credit/debit card.
(3) Policy Reforms Needed for sustained decrease in the share of black economy in GDP and national wealth: PIT simplification & rate reduction, end of tax terrorism, stamp duty reduction, lower circle rates, promotion of mobile wallet; State financing of elections, rigorous auditing of accounts, penalties for non-compliance including eventual de-registration, removing criminals from politics (all to be implemented/supervised by Election Commission), criminal justice system reform (law-police-judicial). 

Economy Impact

      Such a large demonetization has significant positive and negative effects on the economy. On the positive side, it's a blow to Cross border counterfeiters, corrupt politician-bureaucrat-police, and to operators of the 60-40 land-real estate system. The demonetization will make it impossible to use undeclared income, and thus put severe downward pressure on prices. It's conceivable that almost the entire black component of price is eliminated, bringing down prices by 30% to 50%. But this cannot happen if govt rules like high "circle rates" make it impossible. State Govts must quickly eliminate rules & procedures which can keep real estate prices from falling and reduce stamp duties, an outdated transaction tax that discourages transparent deceleration.
  The other channels for holding black wealth such as jewelry & foreign currency (hawala),  will also be reduced, but the effect will be mostly on volumes, not much on prices, as these are set by international markets. Conspicuous consumption in the form of extravagant wedding ceremonies is also likely to be moderated. However, the effect on these items will not last beyond 3-5 years, unless complementary measures are taken to reduce new generation of black money.
     On the negative side, retail trade in goods & services (including daily labor) will collapse in the first few weeks. To the extent the rural areas usage of cash is higher relative to cheques & cards, economic activity will be affected more than in urban areas. The speed/slowness of retail recovery is directly related to the speed/slowness with which the transaction demand for currency by users of retail services is met, in each geography (city, district, block, Panchayat). RBI must ensure supply of new lower denomination notes upto & including Rs.500 one, in every geography: In the absence of Rs. 500 and Rs. 1000 notes, the need/demand for Rs 100 notes increases manifold and must be met. New Rs. 500/- notes need to be introduced quickly as Rs. 2000 notes are not even a pale substitute for the de-monetised 500 & 1000 notes for the purpose of transactions/trade.
    Wholesale trade & manufactures are less effected by currency shortage as they can increase use of cheques (Demand deposits) more rapidly. Banks must facilitate their deposit of cash in bank accounts to expedite it, for instance by having separate lines for depositors having accounts in their bank branch.
    The reduction of corruption in the central govt had already put pressure on the real estate sectors of metro cities like Delhi.  The slow recovery that was underway is likely to be delayed further unless pro-active action is taken to facilitate white transactions in construction & real estate. RBI should bring forward interest rate reduction. Ensure credit for housing & real estate sectors to facilitate its move from being a black sector to a grey/white one.
   Tax compliance & collection will increase dramatically in the current year, because undeclared cash is being deposited in bank accounts and these will have to be declared as income in current year. This is relatively independent of how GDP growth is affected, because the initial reduction in economic activity is largely in the cash economy in which income deceleration was low and tax evasion high. The higher declarations post November 8 provide a great opportunity for tax reduction, so that better voluntary tax compliance is incentivized and sustained in future years. Union & State Govts. should plan to use part of increased revenue to increase construction oriented infrastructure spending to offset lower real estate activity due to elimination of black money.

Monetary Policy Transition

     Many theorists have misunderstood the effect of forced conversion of cash into demand deposits. This conversion leaves money supply, initially unchanged. By forcing an involuntary shift in the currency/demand deposit ratio it dramatically lowers the velocity of money and thus has a deflationary impact, till such time public has the amount of currency that it wants to hold for transaction purposes. Though banks fund position will improve immediately, expansion of money supply, through fractional reserve system is dependent on new loans being given. This will take more than usual time, because of increased uncertainty. Much of this increase in deposits is likely to be reversed as new currency becomes readily available. After all these adjustments the new monetary equilibrium is likely to be one with higher liquidity & lower interest rates.
  This analysis doesn't apply to cash that is not surrendered and becomes immobilized.  In the last demonetization this was estimated at 1/5th to 1/4th of affected currency. Applying this ratio analysts have estimated the immobilized amount could be between 3 and Rs 3.5 lakh crore. The precise amount will become clear only when the transition period for legally converting money ends(December 2016 or March 2017). At that point (other things unchanged) money supply will be reduced by the actual immobilized amount. The impact of this reduction will, however, be concentrated in the black economy, particularly real estate, jewelry and hawala currency, for the reasons given earlier. If the purpose of the whole exercise was to reduce black money Govt has no incentive to offset this reduction and RBI will not offset it. However it provides an excellent opportunity to the MPC to bring forward repo rate reductions and/or for RBI to increase liquidity/credit flow to real estate sector to encourage white transactions.


   Overall the money supply will pivot from black to white economy and the ratio of white to black economy will rise, with corresponding changes in their ratios to GDP. It's harder to determine what will happen to measured GDP as the % of the two types of flows in it is not known. My guess is a fraction of a % point reduction in growth rate in 2016-17 from that projected by me in March 2016. However if the authorities are unable to supply the transaction demand for currency within a month of the demonetization, the negative effects will begin to mount and spread in the under-supplied areas, and could become serious after two months.

Post-Script (8/12/16)

   The 100% incremental CRR imposed on banks negated any possibility of monetary expansion to offset the currency reduction. Thus it has resulted in a severe tightening of the monetary stance during the month following de-monitization. Data available to date suggests that the GDP growth rate for 2016-17 may lower by 0.2% to 0.5% than the forecasts made earlier ( In march 2016 I had estimated that the growth rate for 2016-17 would be 0.2% to 0.5% above the growth rate for 2015-16. This potential acceleration has been negated. Further, the GDP deflator has transformed from a deflationary mode in 2015-16 to an inflationary mode in 2016-17. The consequential over-estimatation of real GDP that arises in CSO from using the UN system of accounts, will likely be converted into an underestimation this year. Thus GDP growth in 2016-17 as measured by CSO is likely to be 7.3% +/- 0.1%. 
   My forecast of CPI inflation (4% to 5% with 70% probability), however remains on target with actual inflation in March at the lower end of this range.

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