Has government bitten more than it can chew via demonetisation? Has PM Narendra Modi bartered graver tangible hit to the economy and masses against little and vague long-term gains? How to weigh the gains and losses of this huge reset minus rhetoric?

As dreaded, demonetisation has started radiating its pain across the economy and by and large, Parliament debates have failed to convince the nation on gains and losses of this exercise. It is high time now to take a critical look at this massive disruption.

First, let’s get down to the facts:

1) Various independent estimates indicate that around 20 per cent of the black money is in cash possession while the rest is parked in land and jewellery.

2) Demonetisation against the black economy is largely limited to inflicting penalties on those who hold their black wealth in the form of cash at the moment of demonetisation.

3) Demonetisation has effectively wiped off 80 per cent of the currency in circulation although India trades and spends mostly in high denomination bills. This currency has to come for exchange in banks and other exchange centres.

4) India’s 11.8 per cent of economy deals in cash. India’s cash-to-GDP ratio is more or less parallel to many big economies. Germany’s cash-to-GDP ratio comes in at 8.7 per cent while the same ratio in France is at 9.4 per cent. Japan has 20.7 per cent cash economy.

5) As we know that cash economy is a complex mix of black and white transactions and cash generated through illegal means is also used in the creation of productive assets and demand, let’s give the cash economy a coherent classification.

Cash economy consists of two types of cash: accounted and unaccounted. Cash can become legal only when it is accounted either in tax or in the bank account. Whatever cash stays out of these accounts can be called unaccounted or black.

6) Whatever size one may estimate for the black economy, so far as the cash economy is concerned, it is perfectly measured and recorded by the Reserve Bank of India on a quarterly basis. Since the RBI keeps a record of every currency note printed, the data of the notes in circulation is synonymous with the cash economy.

How to estimate gains?

If not now, at least after three months, the nation would like to know the net gains of the excruciating disruption. Let’s crunch some numbers on the cash economy to approximate the likely gains:

According to RBI data, India possessed Rs 14,180 billion cash in high denomination by March 2016. Out of this, around 30 per cent or Rs 4,254 billion was with banks and other government agencies, while cash with the public stood at 70 per cent or Rs 9,926 billion.

The moot question is how much cash will come back for exchange and how much cash could disappear from the system?

Going by the history of demonetisation of 1978, as much as 75 per cent of the money had returned in the system, while the remaining 25 per cent was extinguished.

As the current demonetisation has been a shot in the dark and various estimates are in vogue, one can safely assume there would be Rs 2,500 billion to Rs 4,800 billion which may not get converted and stay out of banking or taxation accounts.

This amount could be somewhere around 2.5 to 4 per cent of the GDP depending on the estimate one buys.

However, while we are crunching these numbers, RBI has informed the government that it would take exactly a year to replace 22 billion pieces of currency notes that have been termed illegal tender, if the government presses were to work overtime.

This situation may well force the government to take recourse in currency imports and extension of the time limit of exchange of old notes beyond 50 days.

The exact size of extinguished money may only be available by the end of March, after the closure of the exercise.

One need not be an economist to understand the impact of demonetisation on consumption.

However, we can assume:

1) 5 lakh crore out of Rs 9.9 lakh crore money with the public could come back to the system.

2) As money in circulation counts in RBI’s liability, RBI could be left with about Rs 3 lakh crore as assets or cash payouts after demonetisation.

3) RBI can give this money to the government for investment, dole as the dividend or could take the extinguished money as redundant and may continue with reduced money supply as during the 1978 demonetisation.

Let’s count the curse now

Demonetisation has brought India’s consumption story at a standstill. On one hand, the cash crunch has injected an anaesthesia to India’s colossal trading system while on the other hand, financial markets and the rupee are on a slippery slope owing to unprecedented liquidity shortage. Longer queues for money in front of banks have forced the government to relax withdrawal and exchange norms.

Here goes the count of losses sans rhetoric.

Consumption/Demand

1) India’s household consumption expenditure stands at Rs 2,97,455 per month, according to official data (2013) available on the government portal. The expenditure includes food, groceries, fuel, core services, consumer electronics, etc.

2) One need not be an economist to understand the impact of demonetisation on consumption, as the cash crunch has forced most people to sustain on subsistence buying.

3) Household final consumption expenditure stood at an average of 60 per cent of GDP in the last few years. As India holds 11.8 per cent of its economy in cash, the cash-driven consumption story has come to an abrupt halt. The market is expecting six months of recession and slow recovery by the end of 2017.

4) The market expects GDP growth to decelerate by 0.5 per cent y-o-y in the second half of 2017 with a distinct possibility of GDP growth contracting in the third quarter.

Corporate

1) Consumption-related companies are sweating with the fear of huge setback to sales during the next three to six months. The top 10 consumption-related companies have lost more than Rs 1.5 lakh crore of market value since the note ban.

2) Cash flows may remain choked till liquidity eases, so does fresh investment and marketing expenditure.

Banking system

1) Banks now suffer with the problem of plenty. They have got a gigantic pile of money to handle, which may cost heavily in terms of deposit rates and management costs.

2) Banks have deposited over Rs 1.5 lakh crore with the RBI by the reverse repo window, till the last count. Deposits with RBI, via banks, will keep rising and RBI has to cough out huge interest on them: about 6.2 per cent per annum.

3) The balance sheets of banks are in no position to manage this abundance via benevolent interest payments. They have already started reducing deposit rates and may wish for early withdrawals of deposits as credit demand has yet to make a comeback.

4) Debt service flows likely to register a slowdown (even for a short period) and banks can see a rise in non-performing assets in the retail sector, especially in rural areas where a large part of transactions are in cash.

Smaller businesses may also find it difficult to meet bank payments on time. Banks will likely have a relook at their underwriting processes for retail/rural lending for the next few months, given the uncertainty in cash flows, implying a potential slowdown in retail growth.

5) Banks will have to keep their regular business of loan disbursals, recovery and financial intermediation in abeyance till the cash crunch gets over.

Government

1) While Rs 3 lakh crore bonanza in the form of extinguished black money is still uncertain, the government will have to bear the brunt of Rs 11,000 crore on account of cost of currency printing.

2) State governments are bracing for lower tax collection on account of reduced land registrations and tepid VAT collections. The Centre may lose service tax and excise duty owing to halted production and sales.

3) Lower revenues may push additional borrowings in the last quarter of the year.

Politicians adore disruptions even though the economy demands stability to flourish. The demonetisation purge appears good for Narendra Modi’s political narrative but comes at the cost of economic growth.

As of now, the cash crunch has turned India into the world’s fastest slowing economy, however, the jury is still out.

Also read: Demonetisation: When elitism trumped common sense