Demonetisation of Indian currency; what next?Cost-benefit analysis provides the answer
Mocking at Prime Minister Narendra Modi’s repeated assertion that the short-term pain being caused by demonetisation would be followed by long-term gain to the vast majority of the people, Dr Manmohan Singh quoted famous economist J. M. Keynes that ‘in the long run we are all dead.’. It is a typical reaction of theoretical economists like Dr Singh when cornered. Keynes himself is famous for suggesting short-term measure – increased money supply to improve purchasing power to revive idle productive capacity – for quick economic recovery. Dr Singh knows very well that Prime Minister is also talking of gain starting from the end of the short period of transition.
All the pains and pleasures, costs and benefits, being talked about can be divided into three broad categories: (a) cost (pain) and benefit (pleasure) to human beings, (b) cost and benefit to political players, and (c) cost and benefit to the economy in terms of GDP.
Theoretically cost-benefit analysis (CBA) of pains and pleasures to individuals is possible and have been attempted by researchers but there are practical difficulties because of the possibility of value judgements in the absence of reliable data. Supporters of demonetisation are pleased at the prospect of the corrupt losing their ill-gotten money amassed at the cost of common people. At the same time, vast number of people including supporters are suffering and losing patience. Lakhs have lost job and millions are waiting for hours in ques before banks and ATMs (latter problem aggravated by corrupt bankers and money launderers). There are also reports of loss of human lives because of physical and/or financial strain. It is impossible to quantify all these pains and pleasures. At best, attempts can be made later when researchers collect data.
The conventional CBA methodology cannot be applied to measure costs and benefits to political players in terms of loss and gain of popularity ultimately reflected in the number of seats in elections and financial loss and gain to contestants and parties. All the electoral victories and defeats cannot be attributed to a single factor. Right now, opposition politicians have gone berserk because of erosion of their money power and fear of losing ground to Modi. If Modi has gained new supporters, he must have lost many old ones. In his own constituency thousands of weavers have lost job. Anyway, I leave the analysis of loss and gain to politicians to political analysts.
CBA of impact on economy in terms of GDP is also not as simple as CBA of an investment project. For an investment project, it is possible to identify and quantify direct as well as indirect costs and benefits and to compare the two situations: ‘with’ (i.e. with investment in the project) and ‘without’ (i.e. without investment in the project) to get an idea of gain or loss that can be attributed to the project. Reliable numbers would be available only after nationwide statistics are collected and analysed. Moreover, even if loss to the economy (i.e. fall in GDP) is quantified, it is almost impossible to quantify subsequent gains which could be attributed exclusively to demonetisation. Therefore, for any CBA one has to manage with estimates to assess the implications.
Supporters as well as opponents are unanimous that demonetisation has slowed down economic growth, though they differ on its duration and magnitude. At the beginning of the current fiscal, the Central Government had set the target of 8% growth in GDP. As against that, it was only 7.1% in the first quarter of 2016-17 and 7.3% in the second quarter. The RBI’s latest estimate (on account of demonetisation) is 7.1%, as against the earlier (before demonetisation) estimate of 7.6%. The other estimates are in the range of 3.5% (Ambit Capital) and 7.3% (Morgan Stanley) in 2016-17 and 5.8% (Ambit Capital) and 7.7% (Fitch).
There are different estimates of return of cash to the banking system and the implication of the unreturned cash. Till December 10, out of high currency notes worth ₹15.5 lakh crore (on November 8), an amount of ₹13.3 crore has returned to the banking system, though the State Bank of India (SBI) has doubts about the RBI’s estimate because of the possibilities of double counting (inter-bank transfers and deposit of new currency notes). The SBI’s own estimate of un-deposited cash – about Rs. 2.5 lakh cr. - has been completely demolished by Revenue Secretary Hasmukh Adhia who has said that the government expected all the demonetised money to come back to the banking system. Being Revenue Secretary, Adhia is supposed to know everything about taxation and black money. If all or most of the high-value currency notes in circulation on November 8 return to the banking system, then all the rumours about politicians and others hoarding hard currencies in gunny bags will prove false or would mean that they succeeded in moving all their cash to banks. In either case, Prime Minister Modi will have to face attacks from his political opponents as well as economists and financial experts. (What will be reaction if more than Rs. 15.50 lakh cr. returns? Will it be due to counterfeit currencies entering banking system or duplicate notes in circulation?)
Whether Revenue Secretary’s expectations prove true or false would be known only when the time limit for deposit is over. However, with lakhs of legal windows kept open by the government (it amounts to ‘demonetisation in phases’) and lakhs of illegal channels provided by corrupt bankers, charitable trusts, NGOs, priests of temples and money launderers, besides Jan-Dhan account holders, the chances of return of most, if not all, of the black cash have increased.
Initially many experts claimed that to the extent cash did not return to banks, there would be windfall to the government because the RBI would return equivalent amount of cash to the government as special dividend. The RBI has clarified such amount will be reflected only in its balance sheet, not in income statement. The Government is likely to amend the RBI Act to collect the surplus.
In the absence of data for CBA in the conventional sense, I have adopted a different approach. I have first considered cost in form of loss of GDP and then carried out a set of sensitivity analyses to estimate growth rate required to recover the loss and then to achieve significant improvement in the economy.
Assumptions and methodology for evaluation of impact
(a) Numeraire (accounting unit) is GDP measured in Indian rupees at 2015-16 prices. GDP captures results of all economic activities: monetary value of all goods and services produced when measured by output method, total expenditure incurred by all entities on goods and services when measured by expenditure method and total income earned by the factors of production when measured by income method.
(b) Cost to the economy is loss of GDP compared to the growth expected in 2016-17 without demonetisation. Benefit is increase in GDP when the economy picks up in later years, though it would not be realistic to attribute entire incremental benefit to the after-effects of demonetisation. ((It is not correct to deduct additional revenue collection from loss of GDP to arrive at loss or gain attributed to demonetisation. These are two different numeraires).
(c) 7.6% has been assumed to be the growth rate in 2016-17 without demonetisation. In 2015-16, India’s GDP (at current prices) was Rs. 135.76 lakh cr. At 7.6% growth rate, GDP for 2016-17 works out Rs. 146.08 lakh cr. without demonetisation and Rs. 145.40 with demonetisation (at 2015-16 prices). Thus, going by the RBI estimate, demonetisation would result in loss of Rs. 0.68 lakh crore only.
(d) Since fall in GDP in the current year and/or next year is still an estimate and different experts have given different estimates which may be quite different from the actual number available later, sensitivity analyses have been carried out assuming different rates of decline. Similarly sensitivity analyses have been carried out assuming different rates of growth of GDP in later years.
(e) Discount rate is 6.5% which is the close to 10-Year Government Securities Yield (6.51% of November 18, 6.28% on November 25, 2016).
The assumptions about significant jump in growth may not be realistic but the sensitivity analyses give a broad idea of the challenges ahead. Unless post-2017 fiscal, growth rate is more than 8%, loss caused by demonetisation would not be compensated. Lower the growth rate in 2016-17, longer the time to make up the loss. In the worst scenario assumed – growth rate of 5.5% in 2016-17 and 6.5% in 2017-18 (if the set back to the economy persists) - even 11% growth in subsequent years will not be sufficient to make up the loss by 2020-21.
The biggest challenge is to raise the growth rate substantially, at least to 10% by 2018-19. It may be difficult but is not impossible. Improvement in tax collection as a result of disclosure of black money (this year) and drastic reduction in cash transactions will enable the government to make more investment in infrastructure. Banks will have more funds for lending. More investment in creation of capital assets will generate more employment which will improve people’s purchasing power. However, availability of funds alone is not the only condition. Implementation of projects depends not only on the availability of funds but also on the availability of land timely clearances and skilled manpower. Considering the mounting burden of the NPAs (non-performing assets), banks may not be liberal in sanctioning fresh loans. The private sector will definitely demand structural reforms like labour reforms, which is not an easy task in a democracy like India.
Reduction in terrorist and naxal activities –already hit hard by demonetisation – should also improve growth rate. Moody's studies show that terrorist attacks cause decline in investment and cut growth of GDP by 0.5 to 0.8 percentage points and the negative impact continues for years after attacks. Reduction in corruption, if achieved, will also contribute to higher growth. Management guru C. K. Prahalad’s studies show that ‘the lost opportunity caused by corruption, in terms of investment, growth and jobs for India is over US$50 billion a year.’ According to the Transparency International, rampant corruption in welfare schemes such as MNREGA and National Rural Health Mission reduces poor people’s purchasing power.
The bottom line is the growth rate will ultimately depend not just on better management of the economy but also on drastic check on corrupt practices. Common people expect Prime Minister Modi to take stringent anti-corruption measures and to improve transparency in economic activities and public life. My observation is that in our country, corruption is much wider and deep-rooted than what common people believe. Reduction in political corruption due to reduced availability of cash for fighting elections should also lead to all-round reduction in corruption in the country.
Much of the benefit will depend on Modi’s leadership.
(Former head of the Project Appraisal Division of the Planning Commission)
December 12, 2016
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