Even as prime minister Narendra Modi-led government has been taking multiple measures to discourage the use of currency notes to accelerate India's shift towards digital transactions, cash is still king for the Indian economy. An analysis of the impact of demonetisation - published by renowned economists in a working paper brought out by a US institution National Bureau of Economic Research (NBER) - shows that in modern India cash continues to serve an essential role in facilitating economic activities.
Due to the same reason, the study estimates that the decline in cash lowered the growth rate of the economic activity by at least 2 percentage points in the quarter when the demonetisation of large-value currency notes happened in November 2016. Former Prime Minister Manmohan Singh had also arrived at a similar conclusion when he said that the Indian GDP might take a hit of 2 percentage points due to demonetisation.
The authors of the NBER paper - Gabriel Chodorow-Reich, Gita Gopinath, Prachi Mishra, and Abhinav Narayanan - estimated the impact on the economy by looking at the decline in nightlights-based economic activity during this period and demonetisation's cross-sectional effects on employment over districts.
"Combining these two results yields a decline in nightlights-based economic activity and of employment of 3 percentage points or more in November and December of 2016 relative to the counterfactual path, which translates into a decline in the quarterly growth rate of 2 percentage points or more. Similarly, the effect on credit implies a 2 percentage points or more decline in 2016 Q4," the paper points out.
The researchers opted for studying the consequences of demonetisation in the cross-section of Indian districts as "the national time-series aggregates" have limited coverage of the informal, cash-intensive sector of the economy. They used a comprehensive data set from the Reserve Bank of India (RBI) containing the geographic distribution of demonetised and new notes to construct a local area demonetisation shock as the ratio of post-demonetisation to pre-demonetisation currency in an area.
The authors claim that the study has drawn outcomes from a number of different data sets many of which had not been previously used in academic researches. The study also shows that districts that had experienced more severe demonetisation shocks saw much larger contractions in ATM withdrawals.
"The link between currency availability and cash withdrawals validates the usefulness of our geographic shock measure and provides prima facie evidence of a cash shortfall. We next show that the demonetisation had an adverse effect on the real economic activity," they say.
The authors also used a new household survey of employment and satellite data on human-generated nightlight activity to measure demonetisation's effects at the district level. "These variables capture both formal and informal sector economic activities.
Both variables reveal economically sharp, statistically highly significant contractions in areas experiencing more severe demonetisation shocks. The effects on real economic activity peak in the period immediately following the announcement and dissipate over the next few months as new currency arrives.
In terms of magnitude, both variables map a difference in output of roughly 4 percentage points between districts at the 10th and 90th percentile of the demonetisation shock in the period immediately after the announcement. These results reject neutrality of money during demonetization," the report suggests.
The authors say that the analysis highlighted two main findings: First, it provided well-identified and statistically strong evidence of an effect of money on the output in the cross-section of Indian districts. Second, it shed light on why cash matters.