Foolhardy to assume demonetization would extinguish black money, govt research paper

Did Prime Minister Narendra Modi go ahead with demonetisation of Rs 500 and 1000 notes without allowing any expert analysis of the impact it might have on the economy? It would seem so, if a recent paper by a research team attached with a Union finance ministry outfit is any indication.

Terming the step “a large shock to the economy”, the research paper says, the Government of India has been arguing that the cash that would be extinguished would be “black money” and hence, should be rightfully extinguished to set right the perverse incentive structure in the economy.
Pointing out that “this argument is based on impressions rather than on facts”, the paper argues, “Facts are not available to anybody” on what might happen, and that “it would be foolhardy to argue that this is the only possibility.”
Titled “Demonetisation: Impact on the Economy”, the paper has been prepared by researchers Dr Kavita Rao, Dr Sacchidananda Mukherjee, Dr Sudhanshu Kumar, DP Sengupta, Suranjali Tandon and Hari Nayudu of the National Institute of Public Finance and Policy (NIPFP), New Delhi.
The researchers say, “If this currency is extinguished there would be a contraction of economic activity in the economy”, giving the example of a small trader depositing Rs 2 lakh in the jan dhan account, saying, “Since the currency in which he held these balances in for transactional purposes has been scrapped, it would be incorrect to interpret this as success of the programme in bringing in people who were hiding black money.”
Pointing out that sectors that would particularly impact include “transport services, kirana, fruits and vegetables and all other perishables”, the scholars says, they would “would face compression in demand which is backed by purchasing power.”
The scholars strongly dispute those who say that, as supply would exceed demand, there would be a fall in prices, saying, “If supply too gets curtailed for want of a medium of exchange, prices might, in fact, rise.” They add, “The expectation that inflation would decline might be belied.”
The scholars believe, while “the demand from segments which have access to digital medium of exchange would remain unaffected”, as for the rest of the economy, it would get compressed, and “this would transmit the effect to the rest of the sectors in the economy.”
As for the real estate, the paper says, “contraction in demand” of unaccounted incomes would mean fall in its transactions, with some activities ceasing to happen, adding, the compression in investments in the construction sector “can have adverse income and employment.”
Coming to the impact on the agricultural sector, the paper says, “This is the sowing season for the Rabi crop in some parts of the country and the harvesting season for the Kharif crop. Most of the purchases and sales in this segment of the economy are carried out through cash.”
“With the elimination of cash from the economy, sale of kharif crop would be difficult unless the crop is sold on the promise of payment in future”, the scholars say, adding, “Given the limited bargaining power of the farmer, the price they can realise for the crop can be adversely affected.”
“On the other hand”, according to the scholars, “in the sowing activity, people would not get access to the inputs required since most of the inputs are now purchased from the market unless they seek access to credit from the supplier. In other words, with demonetisation, there would be a significant strengthening of the informal sector credit market in the rural economy.”
At the macro level, the paper says, the official expectation appears to be that the cash being extinguished would result lead to the possibility of “expansion in potential credit creation” because of “sufficient demand for credit.”
Disputing this view, they say, “It is not correct to assume that expansion in credit will definitely materialize… Demonetisation has been introduced in an environment where demand for credit is rather low. A compression in demand in the economy would further depress the sentiment driving investments.”