With remonetisation in full swing and the post-demonetisation cash squeeze almost over, the Economic Survey 2017 presented in Parliament today by finance minister Arun Jaitley says the impact of demonetisation on GDP growth will be transitional and will return to normal by April.
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 6.75-7.50 per cent, says the Survey.
The Economic Survey points out that demonetisation will have both short-term costs and long-term benefits. Briefly, the costs include a contraction in cash money supply and subsequent, albeit temporary, slowdown in GDP growth; and benefits include increased digitalisation, 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 digitalisation 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 per cent in December, rather than 62 per cent in November since many of the old high denomination notes continued to be used for transactions in the weeks after 8 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 0.25 to 0.50 percentage points compared to the baseline of 7 per cent.
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 FY18.
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 8 November 2016 with the announcement of demonetisation. 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.
The Survey suggests a few measures to maximise long-term benefits and minimise short-term costs.
- 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;
- Continued impetus to digitalisation 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;
- Following up demonetisation by bringing land and real estate into the GST;
- Reducing tax rates and stamp duties; and
- An improved tax system could promote greater income declaration and dispel fears of over-zealous tax administration.
The immediate effect of demonetization through end-December was a spike in bank deposits, which will decline, but probably settle at a slightly higher level
RBI's balance sheet remainted largely unchanged: return of currency reduced the central bank's cash liabilities but increased its deposit liabilities to commercial banks.
RBI's balance sheet will shrink, after the deadline for redeeming outstanding notes.
Interest rates on deposits, loans, and government securities declined while the implicit rate on cash increased. Loan rates could fall further, if much of the deposit increase proves durable.
Stock of black money fell, as some holders came into the tax net. The formalisation should reduce the flow of unaccounted income, which, in turn would cause a reduction in private sector wealth, since some high denomination notes were not returned and real estate prices fell.
Private wealth could fall further, if real estate prices continue to decline.
Prices declined, as wealth fell while cash shortages impeded transactions. Prices could fall further as investing undeclared income in real estate becomes more difficult; but tax component could rise, especially if GST is imposed on real estate.
Digital transactions amongst new users (RuPay/ AEPS) increased sharply; existing users' transactions increased in line with historical trend. However, some will return to cash as supply normalises, but the now-launched digital revolution will continue.
Growth slowed, as demonetisation reduced demand (cash, private wealth), supply (reduced liquidity and working capital, and disrupted supply chains), and increased uncertainty. But, demonetisation could be beneficial in the long run if formalisation increases and corruption falls.
Cash-intensive sectors (agriculture, real estate, jewellery) were affected more.