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Sunday, November 13, 2016

Will Demonetization cause Recession in India?

On my trip back to Benguluru from Mumbai, I realized that traffic on famed Bangalore streets appeared to be much thinner than usual. As they say, cab drivers have the best pulse of the city, so I decided to chat up with my cab driver on how the recent demonetization and withdrawal of Rs 500 and Rs 1000 notes is affecting him and the city in general.

I half expected him to strongly complain about the sudden move and how the common man on the streets is facing tremendous issues because politicians in far away Delhi has decided to clean up the black money. However, I was surprised to hear cab driver's positive opinion and subsequent praise he heaped on Prime minister Modi. In his half broken Hindi, which he spoke with great spirit, he informed me on the heaps of notes being burnt in Benguluru halli's, his 15,000 savings on hand that he is unable to use now, and his views on changing political dynamics of whole country because of this move.

The current surge of patriotism in our country is unmistakable. But have we committed a hara-kiri in pushing the fastest growing economy in the world in a tailspin of recession, unknown economic ramifications and political uncertainty. Lets have a quick look to analyze this.

Demonetization in India is a cyclic affair and is a political tool as well. Every 30-35 years, Indian governments have implemented this tool, however with limited success. The subsequent impact of these demonetization drives which happened in 1946 and 1978, is neither well documented nor studied in depth. As we can see in GDP growth rate chart for last 50 years, India's economy was well under water for next two years following 1978 demonetization.

Output in manufacturing sector fell in both 1979-80 and 1980-81 and crisis spread to construction, transport and trade sectors as well. The recession and fall in private sector investment was severe inspite of public spending going up in these two years. Aggregate consumption and fixed investment slowed considerably in year 1979-80. Reduction in wages in various sectors was to the tune of -4% to -8% across various sectors in these two years. All these factors contributed to a negative GDP growth rate of -5.2% in year 1979-80, thus resulting in one of the most severe recessions of last 50 years. Political uncertainty and economic stagnation resulted in regime change in center in 1980 when Janata government fell.

However, as hopefuls always maintain, this time it is different. Urban India has moved to Internet banking, online transfer, credit card, debit card and cashless payments. On my two day trip to Mumbai, I had only four hundred rupees cash in my pocket, and paid for airfare, hotel and taxi via credit card and still had my prized possession of four hundred rupee notes intact in my pocket when I came back to Benguluru. However, as my knowledgeable cab driver informed me, cards and online transfer is only used by a small minority even in urban India. And when it comes to rural India, cash economy is the only available option, which is suspended currently for at least the next few weeks to come. The long serpentine queues and minor law and order situation in front of ATMs today is maybe just the tip of the iceberg.  

The impact on economy will be more severe than anticipated. The usual suspects are cash based sectors like real estate, election spending, small traders, agricultural trading, small retailers, jewelry, weddings, luxury brands, and many more sectors which contribute in a large way to Indian economy. Indians will have less cash and will spend less, hence it directly contributes to lower GDP growth for the next 1-2 years.  

To increase economic growth in a country, typically governments try to purchase bonds and push more money circulation in the economic system. This is known as Keynesian stimulus in economic terms. The current demonetization will suck large amounts of cash from the economic system, and hence will be counter productive for India's economy. Cash money hoarders will prefer to burn their cash, instead of paying 200% penalty and hence total money available in Indian economy will reduce, pushing India to recession. Less money available in system contributes to less expenditure and hence directly results in reduction of economic activity.  

Reduction in business and economic activity, results in a cycle of reduction of wages and available money in hand of common worker, which in turn again reduces the amount of his/her purchases made on food, clothes, transport and common expenses, hence impacting business and creating more cyclical slowdown. I was reluctant to share the bad news with my taxi driver, that probably in next 1-2 years, he should prepare for less people taking a business trip from and to Bangalore, which will result in less taxi trips for him and impact his take home salary.

The biggest impact will appear when this gets coupled to impending rate hikes in US economy. Fed authorities have signaled a rate hike regime in US, which is nothing but movement of money to US bonds, hence reducing the money available for investment in developing economies such as India.
Combine this with reduction in money available within Indian economy and results can be temporary slowdown at best and full fledged recession at its worst.

Coming back to the point I raised in article earlier, we have possibly committed a economic hara-kiri in pushing the fastest growing economy in the world in a tailspin of recession and unknown economic ramifications. The best followup actions for Indian government now is to bring banking system on its feet back as soon as possible, increase public spending drastically, plan in advance for next 2 years and take large scale initiatives in job creating sectors to minimize monetary impact. And meanwhile, I am planning to take bus transport instead of taxi for my next trip out of city to save some cash!

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