Modi's black money gambit bold but govt must manage uncertainty

Prime Minister Narendra Modi’s announcement to demonetise Rs 500 and Rs 1,000 currency notes on Tuesday is, without a doubt, the boldest assault on India’s infamous black economy, which, according to a 2016 report by Ambit Capital, forms a fifth of the Indian economy. Mr Modi said the move was meant to counter the combined evils of corruption, black money, and a fake currency racket that also funds terrorist activities against India. He pre-empted the obvious outcry over the inconvenience by urging Indians to “ignore the temporary hardship” and join in this “festival of integrity and credibility”. The move should be welcomed as Mr Modi has indeed taken a decisive step towards fulfilling one of his 2014 Lok Sabha election campaign’s key promises, curbing corruption and making efforts to recover unaccounted money.

 
However, the government would do well to assess the possible secondary impacts, which may adversely affect the economic recovery. Based on a back-of-the-envelope calculation, if the total value of Rs 500 and Rs 1,000 notes is Rs14 lakh crore, then presuming 20-25 per cent black money, the demonetisation move has in one stroke taken around Rs 3 lakh crore out of the system. It is anybody’s guess how much of this will come back by March 2017 and boost the government’s tax revenues. The fear of being prosecuted and the prospect of a steep penalty later might lead to a substantial amount of this money never returning to the system.

 
Asset destruction of this kind might still have only a minor impact on gross domestic product (GDP). But the knock-on effects of such a crunch in money supply might be more substantial. Take, for instance, real estate prices, which are directly affected by black money. They are likely to fall both in the secondary as well as the primary markets. This would lead to a freeze in transactions at a time when banks were increasingly dependent on retail loans. Moreover, a fall of, say, 25 per cent in housing prices can further exacerbate the defaults on home loans, hit consumer confidence and throw a spanner in the works for an economy trying to recover through a good monsoon and Seventh Pay Commission payouts.

 

As far as its effectiveness in curbing black money is concerned, Tuesday’s demonetisation will only affect the stock of black money. It, per se, does not inhibit the flow (or the future creation) of black money. For that, the government needs to track cash transactions more closely, including, and most importantly, electoral funding in India, apart from redoubling efforts to move towards a less-cash system. Going forward, the key challenge for the economy is uncertainty. The performance of the markets on Wednesday was symbolic, the Sensex swung wildly, losing close to 1,700 points before recovering to close 339 points down. In the context of the US election results and what they have done to world markets and the prospect of a reversal of globalisation, the medium-term impact could be bearish. So the real risk is the secondary effect on asset markets, and the downstream effect on consumer mood and demand.

 
The short-term impact would likely bring down GDP or inflation, or both. But that also opens a door for an interest rate cut by the Reserve Bank of India, which can then kick-start the investment cycle. On its part, the government should focus on the timely disbursal of Pay Commission dues as well as ensure the volume of new currency reaches the market in time so as to not hold back economic activity.