The DeMo Effect: The Humbug of Demonetization, Any Lesson!


The discussion on demonetization has again revived due to slowing down of the economy in recent quarter. The stated objective of demonetization was fourfold: to curb corruption, to check counterfeiting of notes; controlling use of high denomination currencies for terror activities; and restricting accumulation of black money in the economy. The Economic Survey accepts that demonetisation had been a radical and unprecedented step resulting into short term costs but with long term benefits. (Economic Survey 2016-17, part I)

The government claims, the liquidity squeeze was less severe than argued by mainstream media and economists and it has eased since end of 2016. A number of measures has been taken up to control the unwanted costs and leverage the benefits of demonetisation, such as: considerable remonetization; improvement in digitalization in financial transactions, follow up tax reforms including reduction in tax rates and stamp duties, simplification in tax administration and implementation of GST regime. These actions, the government hopes would lead growth to return to its trend in current fiscal after the supposedly less severe and temporary decline in 2016-17. Let’s see the things in perspective.

The Quarter 1 data of GDP released by Central Statistical Organisation (CSO) for this fiscal paint a shadowy picture about the Indian economy. At 5.7% growth rate of GDP it is the lowest in last three years. It is far below the 7.9% growth rate achieved a year back (Q1 of FY17) and even lower than the last quarter figure of 6.1% (Jan-Mar 2017).

The Quarter 3 data for October-December 2016 had put the GDP growth rate at 7%, defying the impact of demonetization on growth during this period. It was immediately declared by the Indian government as its victory over the critics who were opposing over the likely negative impact of demonetisation on economy’s growth. The Prime Minister had declared this success in a public rally in UP as the result of ‘Hard-work’ over so called ‘Harvard’ wisdom of prominent economists of Amartya Sen and Manmohan Singh who had described demonetization drive as a ‘despotic action that has struck at the root of economy based on trust’ and ‘organised loot and legalized plunder’ respectively. The distress faced by common man in particular the rural distress was also denied the Finance Minister. (Indian Express, 2 March 2017).

The government was upbeat about the last quarter forecast of fiscal year 2017 which was estimated by CSO at 7.1%. However, to answer the critics, the government had taken a position that the disruption in economic activity caused by the demonetization would at best be a ‘temporary blip’ spread over few quarters and likely to be eliminated by April 2017.

The Economic Survey 2016-17 pegged the overall growth rate of the economy for fiscal 2017 at 7.1% and that of fiscal 2018 between 6.75 and 7.5 per cent. International rating agency CRISIL forecasted growth of this fiscal at 7.4%. However, as government expected lower impact of demonetization on the economy, CRISIL expected the impact to fall on the growth. Even Nomura had doubted the CSO forecasts as underestimate as government data captures mostly ‘organised sector data’ and suggested that “consumption and services were hit after demonetisation because they are more cash-intensive” (The Hindu, 2 March 2017) Moody, IMF and OECD all had forecasted about the temporary disruption in private consumption and economic growth due to demonetization.

Recently however, the RBI Monetary Policy Committee had expressed concern about the upcoming slowdown in the economy. But government data put the provisional growth rate in 2016-17 at 7.1%. And that is what getting reflected in first quarter GDP growth. But the question is can we attribute this slow down to the demonetization or DeMo Effect?

It is well known that the demonetization caused temporary but significant disruption in economic activity during and after the 50 day window post November 8, 2016 in the form of cash cruch, shut down of small businesses and manufacturing units, significant halt of rural and urban informal segment business and even retrenchment of workers. But then how to capture these data in GDP? The current GDP estimation procedure does not directly collect data from the informal and unorganized sector- only makes an estimate of it from the economic activity of the formal sector. That’s where the difficulty lies. The cash crunch of informal sector and subsequent decline due to its heavy cash dependence, thus, can’t be accurately captured from the GDP figure. And hence attributing this to the DeMo effect will be difficult to prove.

Anyway, the abrupt cash crunch and drying up of the local finances must have led to decline in output from the informal and unorganized sector. This must then reflect in Gross Value Added (GVA) estimate of the economy- which measures the economy’s final output in a year net of indirect taxes- albeit partially. Let’s see the GVA figures then.

Figure 1: Quarterly GDP Growth and Components

The immediate quarters post DeMo, i.e. the GVA in third and fourth quarter of FY17 was down to 6.7% and 5.6% respectively, from 7.3% and 8.7%. Can we attribute this to DeMo effect? As per CSO, the overall GVA during Q1 of 2017-18 grew at 5.6% vis-à-vis 7.6% during the same period last fiscal. Over 75% of manufacturing GVA is contributed by the corporate sector. And manufacturing GVA only grew by 1.2 % in this period vis-à-vis 10.7% in same period last year. That clearly then reflects as the poor performance of the corporate sector. The private corporate sector (firms listed with BSE & NSE) in fact contracted with -0.9 % at current prices during Q1 of 2017-18 vis-a-vis 10.2% in same period of previous year.

Figure 2: Index of Industrial Production (IIP) after Demonetization

Source: CSO, Govt. of India

The performance of quasi corporate and unorganized segment (with over 20% share in manufacturing) is estimated by CSO with the help of IIP of manufacturing. Manufacturing IIP grew at 1.8 % during Q1 of 2017-18 against 6.7% in the same period of previous year. Manufacturing IIP grew at meager 2.6 and 3.8 per cent only in December 2016 and January 2017 and severely fell to only 0.8 percent next month. Can we attribute to this slowdown in manufacturing IIP to cash crunch- assuming that manufacturing output had a lagged effect and reflecting in February and after?

May be the above arguments hold ground, believing in the government argument of a temporary blip in economic activity. Manufacturing IIP does not exclusively segregate and reflect output performance from the informal and unorganized sector which was severely impacted by the cash crunch. At best we can form an idea about it from the manufacturing IIP data. The manufacturing IIP in the six month period after demonetization till May 2017, were sluggish growing at a monthly average rate of only 2.77%. It finally culminated into the negative zone in June 2017 by contracting by 0.1% with the manufacturing output contracting by 0.4%. Further, the output growth for 8 core industries in July 2017 was very low at 2.4% against 3.1% for July 2016. And for the entire April-July 2017 period these core industries grew by only 2.5% against 6% in the same period last year.

The government defends by taking a position that the impact of demonetisation seems to have fizzled out in the first few months after DeMo effect. And the June contract or the overall Q1 performance of Manufacturing IIP or manufacturing GVA should not be attributed to DeMo effect.

Let’s see how we can explain the overall phenomenon then. We economists tend to make a mistake sometimes to segregate a particular phenomenon from rest of others- to avoid interrelation or autocorrelation among various events. And that’s when we fail to see things in perspective. Amidst the difficulty to quantify the impact of demonetization on informal sector and related slow down due to this, certain things are fairly surely be assumed to have occurred in the post-DeMo economic environment in Indian economy. These are as follows:

  1. Demonetization created cash crunch, for a fairly longer period than claimed- at least a quarter period or more. And as per news reports, it had definite impact on informal and unorganized sector economic activity and employment- albeit as a temporary blip, accepted.
  2. Demonetization created uncertainty in the economic environment, particularly among businesses most dependent on cash transaction and local informal finances.
  3. The stated purpose of DeMo as tightening of tax regime, controlling of tax evasion and wiping out of black money- though are good objectives themselves- led to fair amount of uncertainty as to what stringent and stronger steps the government can take. That itself added fuel in the uncertain business environment.
  4. The abruptness of the DeMo decision coupled with the unpreparedness of RBI caused strain in the economic system.
  5. Uncertainty over GST implementation led to de-stocking of the existing inventories by the firms and thus caused slowdown in April to July period of current fiscal- which is stated to be the reason by the Chief Statistician from the government.
  6. The back to back occurrence of twin balance sheet problem- Demonetization and uncertainty over GST– have led to the current slow down; even reasoned by Raghuram Rajan.
  7. There was already a falling trend of investment demand from the beginning of the 2016-17 and by the fourth quarter, it had entered into the negative zone. (Figure 1) This was due to the high level of non-performing assets (NPA) or bad loans tendered by India’s banking sector. The annual average growth rate of gross NPA during 2011-2015 was a high 45.9 per cent for a 16.2 per cent growth rate in loan advances by banks ( Gross NPA of public sector banks stood at INR 614,872 crore, a surge 56.4% in the 12-month ending December 2016. And total NPAs of public and private sector banks stood at INR 697,409 crore by December 2016 as per Care Ratings (Financial Express, 17 May 2017). Due to high NPA levels of banks loan advances to the industries have slowed down amidst the uncertainty over recovery.

Putting things into perspective and as any indication goes by as of now; the industry has started recovery, but is taking more time and is too slow. This has been acknowledged as a lesson by the government, though not explicitly, but from the recognition of the fact that the economy now needs stimulus measure from the public authorities. This week only, Indian government is seriously thinking to loosening its fiscal purse up to Rs, 65,000 crore or USD 7.7 billion, to infuse liquidity into industry. The government is mulling to infuse liquidity exclusively into public sector banks by an additional Rs. 25,000 crore over the budgeted amount of Rs. 10,000 crore in this fiscal. All this however, by widening the fiscal deficit up to 3.7% of GDP from a target of 3.2% for the current fiscal to check the economy’s further slide into slippery slope.