Decoding Demonetization

Recently, RBI published a report recently stating that 99.3% of cash was returned to banks. With this, many economic (supposed) 'gurus' have reached an immediate conclusion that demonetization was a failure, there was no black money in the market and that the entire exercise was futile. Let's nominate them for "Nobel prize in Economics" at the earliest.

This report was just a "status" on what happened with the banned notes. It was not a report on Demonetization's success or failure. Its made to look like that. Second, the effect of Demonetization should not be measured in how much currency came back to the banks. The effect is not to be measured short-term, but rather long-term, 5-10 years commencing from the day demonetization was implemented

• Does 99.3% return of money mean there is no Black money? That is a funny argument, seriously. And Mr. Chidambaram, the 'economist' actually made that argument. 99.3% return does not mean all returned money is white. It means the owners of the black money found out smart ways to get that money into the banks (bribing the bank officers for the exchange of old notes with the new, putting money into banks via their employees, paying employees months of advance salaries in cash, etc.). In fact the owners of the black money can now be identified. This sudden spurt of money has brought lakhs of people (~18 Lakh) with disproportionate income are under scrutiny, around 7 Lakh registered companies which did not show any transactions in years in their accounts (but which suddenly showed mountains of money appear in their accounts). The tax hounds are expected to get behind the culprits. A key intention of Demonetization successfully achieved. 
• Before demonetization, about 86% of the total money circulated was in form of 500 and 1000 rupee notes. This is an absolute "No". In 2004, it was 34% of total currency circulating.  Instead of that % going down, it grew to a whopping 86% in 10 years ( thanks to Mr. Chidambaram - who for most of the time from 2004-2014 was the Finance minister). Infusing huge cash under the pretext of making cash flow available for the poor, was a mere short-sightedness. It did help the poor (liquidity), but it kept the unorganized sector unorganized (in other words - ensured poor remain poor). For an economy to develop, the unorganized sector (informal economy) needs to convert to an organized (formal) one. 
• 86% high denomination encouraged massive black money. A 'zataka' like demonetization was a must. (Why then 2000 and 500 rupee notes were brought in?. I explain this later in this post).
• With massive cash available between 2004 and 2014, many folks pulled cash out of India via "participatory notes", deposited it in foreign banks and then infused it back into India as "foreign investments". A false alarm of economic growth. An average 8% growth in 2004-2009 should have created massive jobs. It didn't.
• Important point - this 86% got back into the banks. Earlier it was not and that was a big problem. For any country to economically advance, the bulk of the country's money has to be in the banks. This allows infusion of capital, promotion of businesses, lending/borrowing, and thus stimulate economic growth. More importantly, it converts the unorganized sector into an organized one. With more ability to loan, the interest rates would go down. This stimulates investments. With demonetization, banks became ₹15.28 Lakh Crore richer without impoverishing the poor. Also, it forced the masses to put money in banks (always a good practice).
• The massive growth of 500 and 1000 notes (from 34% in 2004 to 86% in 2015) brought in high inflation. Asset prices grew 9-10 times more than the growth in the 1999-2004 era (gold, stocks, real estate etc.). Eg. Real estate prices grew from 200% to 2000%. Any asset that was purchased via cash conventionally (gold, silver, real estate) inflated multi-fold. Economic principles state that a good growth should be based upon how many assets "creation/production" happened rather than Asset inflation. With Demonetization, the inflation tamed, real-estate prices tamed.
• What about fake money? 99.3% does not contain "fake" money. That fake money got demolished overnight. There has been no true account of the fake money that was in circulation.
• The other key outcomes of demonetization: 21% reduction in currency in circulation, 55+ Lakh new tax-payers, 25% increase in ITRs filed, INR 1.7 L Crore inflows in Mutual Funds compared to INR 9K Cr last year. Digital Payments has increased by 56%. This is significant.

Printing New Currency - Cost and Implications:

Mr. Chidambaram tweeted that INR 24K was spent in printing the replacement for 16K Cr of notes. You are hiding some other important facts, Mr. Ex-Finance Minister. Why was India printing bank notes from foreign companies? 95% of paper for Indian currency was coming from 3 international companies and took up to 40% of the total printing cost. Second, the earlier 500 and 1000 rupee notes were printed outside of India (surprising isn't it?). Modi government decided in 2015 to bring all of that paper manufacturing into India. It was also important to change the design of those notes completely. Else it would have given rise to significant fake currency. Mr. Chidambaram, who was the FM for most of the 2004-2014 years, should provide an explanation as to why he did not think of overhauling India set up to print "all" money in India? And why are you hiding the fact that the estimated savings for India for printing all its notes in India from now on is at least 1L Crore? 24K crores to save 1L crores. The math is simple Mr ex-FinMin. And what about the sudden gain for the government of INR 36K crores of unclaimed (benami) deposit as the result of sealing 3L fake companies? Chidambaram does not highlight this gain either.

Why were 2000 rupee notes printed at all?

With sudden removal of 86% of currency, it was important to circulate an equivalent money back into the system immediately. With higher denomination notes you have to make lesser number of notes in the same cost to quickly fill the void. Second, the government deliberately printed 2K notes before 500 notes post demonetization. Although this created immediate availability of cash, it also introduced (a planned) artificial crunch. Merchants were reluctant to accept 2K notes, but ATMs were generously dispensing them. The inconvenience pushed many to go to digital payments. This was a planned move.

If the last 1.5 years are to be observed, the government has been reducing the number of 2K notes in circulation. The 2K notes returned to the banks are not getting recirculated. Neither are new 2K notes being printed. ATMs are rarely providing 2K notes. They instead are providing the new 500, 200 and 100 rupee notes. The grand idea is to make 500 K the highest denomination note (If this Govt comes to power for the second term, they will reduce/remove the 500 rupee notes in circulation as well). In the larger plan, if the country needs to have only lower denomination notes, the number of notes required to be printed is going to be higher. And in that case, it is going to be important to print all of them in India at a much lower cost than what it was earlier. Do the Harvard graduate economists criticizing demonetization understand this? Do they even understand that 86% of high currency denomination is bad for an economy? These are the basics, right?

GDP Growth before and after Demonetization:

The following graph shows the GDP growth rate trend from Q3 ‘14 to Q2 ‘18. 

The GDP was on the decline for 3 consecutive quarters before demonetization. Post demonetization, the GDP declined for 2 more quarters and hit the lowest (5.6) in Quarter ending Jul '17. But then it changed course. It has been on the rise for 4 quarters back-to-back from then reaching 8.2 in Q2 of 2018. If Demonetization was responsible for the two consecutive declining quarter, what is the explanation for the 4 quarters of decline before demonetization? The real reason for this trend is the rise in NPAs (Non-performing assets), in general borrowing and lending declined, money circulation declined. Demonetization did add to the decline in growth in 2 subsequent quarters, but that impact was much smaller a factor. The larger factors were - 1) destocking (because of GST rollout  -manufacturing slowed down) and 2) NPAs. Anti-demonetization economists do not wish to explain these factors and the real reasons. And anti-demonetization politicians (non-economist by degree) have a miserable understanding of economics and don't have the ability to grasp the reasons for GDP decline, let alone the ability to explain it. Now the same politicians are keeping their mouths shut after seeing a rise in GDP for 4 consecutive quarters.

Inflation trend:

The following graph shows the Inflation trend for the last 6 years. The inflation has declined since 2014. If you observe the period before and after demonetization, you would see the inflation has reduced marginally. However, overall, demonetization has had no impact in inflation.

Economic growth should also be measured by parameters like - growth in total assets (rather than just the value of the assets), jobs created, enablement of job creation in future). Demonetization is just one pillar of a four-pillar strategy that the government is trying to build. The GST, Aaadhar, and Jan-Dhan are the other three. These together are positioned to bring in a massive change in India and will put India on a growth trajectory for decades to come, and that too in a right manner. What do I mean by the "right manner"? Assets will grow, infrastructure (physical, educational, economic, connectivity) will grow and not just the GDP. We always measure growth in terms of % of GDP. GDP is "gross" value of the total domestic production. This means if the values of those domestic products get inflated, the GDP becomes higher.  E.g. - Gold prices shot up massively in 2004-2014 era (thanks to the huge cash in the economy, the remained a cash-based purchase. It should have converted to a Digital transaction-based purchase). Real estate prices (which also contribute to GDP) came down - and this was only a sensible thing to have happened. This one single reason was largely responsible for inflation. 

Demonetization was a fantastic move positioned to reformat India economically and position it for future advancement. Its impact should be measured across next 5-10 years and not based on how much money was returned to the banks.

Authored by: Mandar Garge