The government's move to demonetise the Rs 500 and Rs 1,000 currency notes has evoked sharp reactions both in favour and against. Pronab Sen, an economist and former chairman of the National Statistical Commission, is one of the voices that has criticised the government's move saying that the negative impacts would far outweigh the likely benefits. In an interview with Business Today, he explains his stand. Excerpts:
Your view on demonetisation in general?
Demonetisation is done, by and large, under two circumstances. First, when there is too much counterfeit going on. Typically, what happens in those cases is that demonetisation is announced in advance, notes are printed and the process starts. Usually it is done with only one denomination, whichever is the currency that is the most counterfeited currency note.
The second situation (in which demonetisation is done) is hyperinflation. The value of currency is going down, and people have lost faith in the currency. In that situation, what you do is extinguish the existing currency and issue a new one which the government promises that it would be firmly behind it and ensure that its value is not eroded.
Why do you think this was a radical move and what it would be its repercussions?
You made the old currency non-legal tender before issuing the new currency. That has never happened elsewhere. There was no pre-announcement, and that has given a shock to the system. The consequences of this would really depend on how quickly the currency gets exchanged. From all the reports I am reading, and the people who know, everyone is saying the exchange would take at least three months.
Three months with a severe reduction in liquidity in the system - we are talking about 86 per cent of the value of currency. The disruption can be very large and some of the disruption would not be temporary but permanent. For example, if the Rabi sowing cannot take place because of lack of cash, the situation can be very similar to a drought, so you may well see people selling their lands to survive. And this is a permanent effect.
Remember, the single biggest repository of currency is the trading sector and it is one sector that keeps the economy moving. And all that cash is not black money - that is money in transit, money in circulation. You wiped out that money. Nobody can distinguish how much of the money with a trader is white and how much is black. Income tax fellows would be going to assume that the whole amount is black.
If trade gets disrupted, then its consequences, up and down the value chain, are enormous because trade is the heart of the market economy. There also the effect can be permanent.
Is there any estimate as to how much of the black money is in cash?
Not as far as I know. That could be a substantial amount. The tax department has given an estimate that 6 per cent of the black money is in cash, but the error that they are making is that they asked the people that they have raided as to what part of their total unaccounted wealth is in cash and they said 6 per cent.
But a trader has both kinds of money - his own money which he must have deployed in the business and then there is money which is in transition. His own money would be substantial. Money lenders' money is black by and large. So these are fair amount of black cash but these are cash which are in productive use.
Apart from agriculture and trading, which other sectors can be hit by the move?
The entire informal sector would be hit - 85 per cent of our workforce is employed in the informal sector. The NBFC sector is also badly hit because the entire demonetisation process is working through the banking system. What's happening is that the government has kept the NBFCs out of the process of exchanging the old notes, so unless the people who the NBFCs have lent to get their currencies exchanged, NBFCs won't get a single paisa. Which means that their business is frozen. Since NBFCs are a large part of the financial system, this could have huge impact on investments. For example, trucking and transport business gets its entire financing from NBFCs.
What could be the impact on GDP and for how long?
My sense is quite long, certainly more than 4-5 months. As for impact on GDP, that calculation is difficult to make. We have done calculations but those calculations are done on the assumption that we are looking at a continuous system. What happens if the money supply is reduced? Supposing that the RBI does not do open market operation and sucks out 10 per cent of the cash, then the model gives you a result that is 1 percentage point reduction. However, these models assume that there is no disruption.
If you have disruption, then the impact could be much larger. For example, if 50 per cent of the Rabi crop is disrupted, then the impact could be as high as 3 percentage points because that's going to have a huge multiplier effect. (Agriculture accounts for 12 per cent of the GDP, of which half is rabi. So if half the rabi crop is not sown, 3 per cent of your GDP is gone.)
The model (for calculating the impact on GDP) is simple. You assume a stable relationship between nominal value of output and available liquidity, and once you establish the relationship between nominal GDP and liquidity, you see by how much the nominal value comes down if you reduce the liquidity.
Any long-term gains?
Nobody has told me what those gains are. So far as I can make out, people who are talking about long-term gains are saying that if you do this hopefully more tax would come in government exchequer. That might be true. But my suspicion is that black money is generated through tax evasion or corruption, and these are ongoing processes, so unless you have permanent fear why would you stop either of them.
And you cannot repeat this (demonetisation) because this is the worst thing you can do, because if the confidence of the people in the sovereign currency is destroyed, your economy is gone. You will be heading back to barter.
Don't you think this (demonetisation) move has already dented people's confidence in Indian currency?
It has not only dented the confidence, the much more worrying part is that there is a strong rumour going around that in about a year's time the new Rs 2,000 currency would be demonetised with the assumption that people who have exchanged black money for Rs 2,000 notes, will be fixed one more time.
So, if this rumour gets stronger, people would stop accepting Rs 2,000 notes, and that is the main substitute you are getting for the existing Rs 500 and Rs 1,000 currency notes. And if that happens, you are looking at permanent loss of liquidity in the system and that is scary, really scary.
So, one of the things that the government needs to do is to come out and say that please note that the Rs 2,000 currency that we are coming out with will not be demonetised in the near future.
What was the rationale in introducing a bigger denominated currency note?
My sense is they would have anyway introduced the Rs 2,000 note, though nobody is saying so. Think of what has happened in the past 10 years, what the Rs 1,000 note could purchase 10 years ago, you today now need Rs 2,000 to buy that much. Probably they would have printed the Rs 2,000 note and then withdrawn the Rs 1,000 note.
However, demonetisation of Rs 500 is a different ball-game. Bulk of the counterfeited currencies were in Rs 500 denomination. To tackle the menace of counterfeit notes, all you needed to do was to withdraw the Rs 500 notes.
What would be the cost of replacement of the old notes?
Well, the cost of printing the new notes is Rs 12,000 crore. I don't know what the cost is of replacing the note. I don't know what cost banks are bearing for replacing the notes...they are doing nothing but only exchanging cash. Somebody must work that out.
Do you think now that the banks are flush with cash, interest rates and inflation would come down?
Inflation may come down but if there is a supply-side shock, inflation would go up again. If there is supply-side shock, and with time the demand is restored, inflation would go up.
But this whole thing of banks-are-flush-with-cash is just a temporary thing. I can deposit as much as I want but I can withdraw only a limited amount. So, you are forcing me (to keep the money with banks). But at some point of time, when the situation normalises a bit and the restriction on withdrawals goes, people would withdraw cash. So this argument that banks would be flush with cash is basically wrong.
More importantly, lending is only partly a function of how much cash banks have; it is also largely a function of the risk profile of the potential borrower. So, if economic activities are disrupted, the risk will go up. If risk goes up, then interest rates go up.