GDP growth Post-demonetisation | PIB Summary

The Government says that the adverse impact of demonetisation on GDP growth will be transitional. The Economic Survey 2017 presented in Parliament by the Union Finance Minister,  Shri Arun Jaitley states that once the cash supply is replenished, which is likely to be achieved by end March 2017, the economy would revert to the normal.  Therefore, the real GDP growth in 2017-18 is projected to be in the range of 6¾-7½ percent.

GDP growth | What does the Economic Survey say?

The Economic Survey points out that demonetisation will have both short-term costs and long-term benefits.

GDP_Gross_domestic_price_economy_Growth_inflation_356x200_5201_356

  • Briefly, the costs include a contraction in cash money supply and subsequent, albeit temporary, slowdown in GDP growth; and benefits include increased digitalization, greater tax compliance and a reduction in real estate prices, which could increase long-run tax revenue collections and GDP growth.
  • On the benefits side, early evidence suggests that digitalization has increased since demonetisation. On the cost side, effective cash in circulation fell sharply although by much less than commonly believed – a peak of 35 percent in December, rather than 62 percent in November since many of the old high denomination notes continued to be used for transactions in the weeks after 8th November. 
  • Additionally, remonetisation will ensure that the cash squeeze is eliminated by April 2017. The cash squeeze in the meantime will have significant implications for GDP, reducing 2016-17 growth by ¼ to ½ percentage points compared to the baseline of 7 percent.
  • Recorded GDP will understate impact on informal sector because, for example, informal manufacturing is estimated using formal sector indicators (Index of Industrial Production). These contractionary effects will dissipate by year-end when currency in circulation should once again be in line with estimated demand, which would also allow growth to converge to a trend by FY 2017-18.
  • The Economic Survey states that the weighted average price of real estate in eight major cities which was already on a declining trend fell further after November 8, 2016 with the announcement of demonetization. It goes on to add that an equilibrium reduction in real estate prices is desirable as it will lead to affordable housing for the middle class and facilitate labour mobility across India currently impeded by high and unaffordable rents. 

GDP growth | Impact of Demonetisation

post-demonetisation

SectorImpact
 Effect through end-DecemberLikely longer-term effect
Money/interest ratesCash declined sharplyCash will recover but settle at a lower level
 Bank deposits increased sharplyDeposits will decline, but probably settle at a slightly higher level
 RBI’s balance sheet largely unchanged: return of currency reduced the central bank’s cash liabilities but increased its deposit liabilities to commercial banksRBI’s balance sheet will shrink, after the deadline for redeeming outstanding notes
 Interest rates on deposits, loans, and government securities declined; implicit rate on cash increasedLoan rates could fall further, if much of the deposit increase proves durable
Financial System SavingsIncreasedIncrease, to the extent that the cash-deposit ratio falls permanently
Corruption (underlying illicit activities) Could decline, if incentives for compliance improve
Unaccounted income/black money (underlying activity may or may not be illicit)Stock of black money fell, as some holders came into the tax netFormalization should reduce the flow of unaccounted income
Private WealthPrivate sector wealth declined, since some high denomination notes were not returned and real estate prices fellWealth could fall further, if real estate prices continue to decline
 
Public Sector Wealth
No effect.Government/RBI’s wealth will increase when unreturned cash is extinguished, reducing liabilities
Formalization/
digitilisation
Digital transactions amongst new users (RuPay/ AEPS) increased sharply; existing users’ transactions increased in line with historical trendSome return to cash as supply normalises, but the now-launched digital revolution will continue
Real estatePrices declined, as wealth fell while cash shortages impeded transactionsPrices could fall further as investing undeclared income in real estate becomes more difficult;  but tax component could rise, especially if GST imposed on real estate
Broader economyJob losses, decline in farm incomes, social disruption, especially in cash-intensive sectorsShould gradually stabilize as the economy is remonetized
GDPGrowth slowed, as demonetisation reduced demand (cash, private wealth), supply (reduced liquidity and working capital, and disrupted supply chains), and increased uncertaintyCould be beneficial in the long run if formalization increases and corruption falls
 Cash-intensive sectors (agriculture, real estate, jewellery) were affected more.
Recorded GDP will understate impact on informal sector because informal manufacturing is estimated using formal sector indicators (Index of Industrial Production).
But over time as the economy becomes more formalized the underestimation will decline.
Recorded GDP will also be overstated because banking sector value added is based (inter alia) on deposits which have surged temporarily
Informal output could decline but recorded GDP would increase as the economy becomes more formalized
Tax collectionIncome taxes rose because of increased disclosure
Payments to local bodies and discoms increased because demonetised notes remained legal tender for tax payments/clearances of arrears
Indirect and corporate taxes could decline, to the extent growth slows
Over long run, taxes should increase as formalization expands and compliance improves
Uncertainty/
Credibility
Uncertainty increased, as firms and households were unsure of the economic impact and implications for future policy
Investment decisions and durable goods purchases postponed
Credibility will be strengthened if demonetisation is accompanied by complementary measures. Early and full remonetisation essential. Tax arbitrariness and harassment could attenuate credibility

GDP growth | Conclusion

The Survey suggests a few measures to maximize long-term benefits and minimize short-term costs. One, fast remonetisation and especially, free convertibility of cash to deposits including through early elimination of withdrawal limits. This would reduce the GDP growth deceleration and cash hoarding. Two, continued impetus to digitalization while ensuring that this transition is gradual, inclusive, based on incentives rather than controls and appropriately balancing the costs and benefits of cash versus digitalization. Three, following up demonetisation by bringing land and real estate into the GST. Four, reducing tax rates and stamp duties. And finally, an improved tax system could promote greater income declaration and dispel fears of over-zealous tax administration.

Leave a Comment

Your email address will not be published. Required fields are marked *