12 Points To Explain The Impact Of Demonetisation 

In a televised address last evening evening, Prime Minister Narendra Modi announced the demonetization of existing notes of Rs 500 and Rs 1000.

(1) Well timed and well executed. Political credibility enhanced. Politically astute too.

(2) Timing this after the end of the tax amnesty scheme was logical.

(3) No capital flight and no 'rupee is toast'. Overstated. Everything else being equal, withdrawal of currency in circulation, in the short-run, will actually drive up interest rates. May not happen as not all things are equal. Capital flight is not that easy anymore. Tax authorities around the world co-ordinate and there is uncertainty in every currency and perhaps more so. Therefore, 'rupee is toast' is far from a likely scenario.

(4) What Professor Kenneth Rogoff (Harvard) suggested for the USA was extreme financial repression in the context of zero and negative rates. That was a very bad and toxic suggestion. Here, it is not the case. Nor is this an act of 'financial fascism' or that of a totalitarian state. Those are wrong characterisations. No. Citizens are entitled to redemption of old currency notes and they can do so. If ill-gotten and concealed, then where is the right that is being deprived?

(5) Short-term liquidity squeeze could be severe and hence economic activity could suffer. Can last up to two or three quarters. If less, well and good. CLSA and Credit Suisse seem to think that (adverse) economic impact could be significant.

(6) Further, with the eventual design of the GST looking more complicated than originally envisaged and with the timelines getting shorter, uncertainty could be compounded. That risk is non-trivial.  That is why GST should have been more concerned with simplicity, ease of use and implementation rather than revenue considerations. Bold thinking was always needed and more so, in the light of this announcement.

(8) The government could have and should have (it still might) come up with additional economic stimulus too, to offset the dampening effect. Just thinking aloud here: (a) accelerated reduction in corporate income tax along with withdrawal of exemptions; (b) ending uncertainty on GAAR and retrospective taxation or any other blockbuster measure that they might be working on, that would offset the initial adverse economic impact.

(9) Whether this would boost eventually economic activity that is formal remains to be seen. But, orders of magnitude are very difficult to establish and hence, any claim of such improvement in formal economic activity with consequent beneficial tax impacts and other social economic multipliers must be deemed wholly speculative at this stage.

(10) This will not release money for RBI to recapitalise banks. A flow diagram of how it would happen - with money going from RBI to GoI and from there to banks, as a result of this de-monetisation and consequent reduction of currency in circulation – would be helpful. Otherwise, it is fanciful. I have not seen one.

(11) Sovereign credit rating - no impact. Indeed, the risk of a downgrade is as real (or more real?) as that of an upgrade, if short-term impact on economic activity dampens government revenues and widens deficit. No government debt is being cancelled.

(12) Tempting to imagine economic benefits immediately from a structural reform. But, these things usually come with a long lag, if they do and, in the short-term reform or deviation from 'business as usual' usually results in pain and uncertainty. That is the reality.