Deciphering the Demonetisation Demon - I

On 8th of November 2016 PM Modiji in a televised address to the nation announced the policy equivalent of the Indian 9/11. From 9th November Rs. 500/1000 notes ceased to be legal tender - which in simple terms means - they can not henceforth be used for any financial transaction. The Modi government took up the massive task of replacing all those 500/1000 notes - yes all - equivalent in value to 86% of total available cash in the Indian Economy, to new 500 notes and the first time introduced 2000 Re notes.

Any which way we gauge, it is big step (even a huge reform) with wide impact - I try to provide a 360 degree big picture in two parts. Sit back and read calmly

Why did Government demonetise?
According to Modiji (taken from his speech on the 8th) the reason to take such a big step are
1. To tackle the menace of fake currency notes (that allegedly helps fund the terrorist).
2. To control the Black money problem with in the country which is wide and deep.
3. To address corruption that is so deep rooted in the system
4. In later discourse Mr. Arun Jaitley the FM added another dimension : To change the habits/behaviours/mindsets of Indians to help move towards a largely cashless society of honest tax payers.

Obviously the step has implications for everyone in the economy and has many threads to understand its possible impact. Lets try to decipher at least some major ones.

What are going to be the most positive impact of this step

Elimination of Fake currency

Demonetisation has probably eliminated large amount fake currency in the system. This would mean more purchasing power in the hands of those who has true (and also legal) currency. 

I say most, because the fake currency is widely distributed in the system and so it may be in the hands of genuine people too. And much of this currency may finally end up getting converted into new notes too. However, it has surely put temporary brakes on inserting of more fake currency in the system. This is obviously a positive for economic development.

Terrorism Control

The connection of fake currency to popular support in places like kashmir is also long debated. It is believed that terrorists buy support in kashmir for their activities using fake currency. This must be true at least in parts - so that should curb militancy/terrorism for some time. We may be naive to think that fake currencies are the only way terrorism was financed, so this does not mean terrorism is finished by this one act. Yet it shall have the effect of weakening the roots of terrorism. It needs to be followed up by an integrated approach of rapprochement with kashmiris and dealing with militancy with firm and fair way.

Honest Tax Payers Rewarded
Demonetisation is one of the rare steps that rewarded the honest tax payer of the country. For this one fact itself this step should be welcomed and be praised.

In the year 2014-15 1.5% of Indian Population paid some income tax, about 2.8% filed income tax returns. Just 0.15% of the Indian population paid more

than 70% of the income tax collected. what this figures help us understand is that a very-very-very large part of Indian population do not pay taxes and these minuscule proportion of the countrymen (largely formal sector salaried classes) foot the bill for public expenses or Government largesse. This is also the reason for indirect taxation being high in our country, historically. The Government generates a lion's share of its revenues by taxing consumption. This of-course is a double whammy for honest tax payers as they get taxed on their income as well as consumption.These honest tax payers have reasons to be happy because demonetization should in the medium term increase the value of their savings done in cash. 

Could have moderating effect on inflation
Conventional economics suggest that due to demonetization less money will chase available goods. This should bring down prices and hence inflation could come down. (another theory is that lot of money will find its way in the legal channels and hence will fuel inflation. But I disagree - the black money too is available to buy all goods today. demonetization will lead to destruction of at least a part of it)

Should widen the tax net
Earlier, most steps to control black money (like Income disclosure schemes)

rewarded tax evaders and hence disincentvised honest tax payer. This step should increase the number of people paying taxes. In that sense this step is as good a reform, may be more, than the one instituted by P. Chidambaram's five point criteria for mandatory filing of tax returns, that led to widening of the tax net.

Banking System to get more Money
One of the sore issues in our economy today is high levels of NPAs that has kind of crippled the banking system choking credit and hence private investment. One expects huge inflow of black money into the banking system thus supplying it with the needed oxygen. One expects this to be complimented with further cuts in rates by the RBI thus easing out loans and hence may act as long due trigger to the economy.

Government to have an improved balance sheet
The biggest beneficiary of the step would probably be the Government. Even if in desperation, cash hoarders would deposit the money in their accounts paying tax/penalty on the deposits. 

After two years of trying out the Government was coming to terms with the

enormity of task at hand - that of balancing inflation expectation, against need to invest more in the economy, to generate resources for investment specially because private investment was simply not ready to take off, to keeping to the promise of meeting the target of fiscal deficit (there were already murmurs of letting this one go).

In recent times the Government also faced a few jolts to its efforts of triggering the economy because of not very favourable outlook of International rating agencies, or because of its less than flattering performance in the rankings of ease of doing business or because falling exports and Rupee primarily because of its failure to bring about some big ticket reforms otherwise promised in their election speeches. The Governments approach to trigger the economy was based on Infrastructure spending which it did - but economy has not yet started to feel its wheels churning on the ground due to this. Government on the other hand was constrained by limits to how much can it finance.

This step has the potential to fill most of these gaps. The fiscal situation may seem comfortable suddenly, International investors will see it as a major reform signalling that the Government is serious about walking its talk. The Government may also be able to find funds to finance and hence accelerate the infrastructure sectors. It may soon see the banking/finance system also having more liquidity. 

All in all it could lead to improved maneuverability for the Finance Minister and the RBI governor to be more proactive in spending and cutting rates respectively. This then can be considered a big positive to the Economy.

May change Indian habits Marginally

Should we expect that Indians will suddenly wake up to the new digital economy and will start transacting in plastic/electronic money. The answer is obviously a strong no. It will require a strong and sustained campaign to change that mindset (something similar to Swacch Bharat but deeper, wider and more prepared). What the demonetisation does is jolt people to be ready for digital transactions as well. To that extent it works in that direction. But its a long haul to that change in mindset - more on that later. :-)

Modiji Marks his name in the History
I wrote a post on performance of the Modi Government in two years in which I mentioned that Modiji is a man on a mission - he wants to leave a legacy of his own on the posterity. This is one such step. It may have different impact on

different sections of the society and yet he cannot be forgotten for this one step. It is like nehru being remembered for PSUs, Kashmir (and many more), Indiraji for Nuclear test, operation blue star, creation of bangladesh, Rajiv Gandhi for the Telecom revolution, Bofors; Narsimha rao for Liberalisation, Atalji for Golden quadrangle and Second nuclear test, Dr. Manmohan singh for Liberalisation, Aadhar, delicnsing, Nuclear deal and the RTI. I am sure there is more in store from Modiji looking forward.

So is all hunky dory with demonetisation? 
Too long a post and probably bhakts are already wondering whether I have changed sides (because to them I am a modi hater). I seem to be praising the demonetisation as a great step in the interest of the country. Probably it is so but then there, as always is the other side. 

Tune in to the sequel of this post here for the other side of the coin. Judge my inclinations (quite uselessly though) after that. 
would surely like to know of your views, suggestions, criticism et al.