On November 8, 2016, people in India were hit by a financial storm when the major currency notes were demonetized, and Rs 500 and Rs 1,000 notes did not remain legal tender. The government reasoned the demonetization as a step towards curbing corruption, as well as fighting the evils of black money and terrorism.However, let us assess what short-term and long-term impactsthe demonetization may lead to.
Short-term liquidity crunch
Around 86% of the currency value in circulation has been withdrawn by the government. Additionally, most of it has gone without replacement. Thus, a huge currency gap has come into existence with the introduction of the new Rs 500 and Rs 2,000 currency notes. As the new currency is low in utilization, it is bound to create a short-term liquidity crunch, which may last for at least four months.
With the low availability of new currency, especially the most favored Rs 500 denomination, a liquidity shock has hit the country people. If it takes a longer time to resupply the new currency, the liquidity crunch will linger on for a longer duration. According to some reports, only 2,000 million units of Rs 500 currency notes can be printed by this year end. This figure can go up to 10,000 million units by the coming March end. Thus, the crunch is supposed to reflect until this time.
Pain to cash-dependent businesses and poor workers
While some strata of the society are aware of cashless transactions, there are many in India still dependent on cash. In a short time, a major transition to a cashless economy seems to be a distant dream. On top of that, certain businesses like jewelry and real estate are running mostly on cash. Such types of businesses and poor wage workers, laborers, or small traders are most likely to suffer due to cash crunch, as even ATM withdrawals and currency exchange from banks have been limited. The phenomenon may also extend to other industries in a few months.
Expenditure, consumption, production, and employment to suffer
As most active societal segments will not be able to meet their transaction requirements, the expenditure will be low in the absence of liquid money. It will further affect the consumption, as well as the production. To reduce labor costs, firms may further reduce wages and the income and employment of poor working class will suffer in short term. In fact, liquidity chaos will simultaneously impact higher-income individuals too.
The short-term low GDP
As all the above get affected negatively, it is bound to hit the economic growth severely for some time. This can lead to a reduced GDP growth during another four to five months.
Positive effect on inflation
Over a medium term, interest rates may be reduced, as banks will have huge savings in the form of liquid cash people deposited. However, this will not stay for long. Another positive impact may be on inflation, as excess cash supply will be eliminated in the market. This can lead to a slight positive jump in transactions and the economy.
Long-term positive effect on economy and negative on counterfeit currency
Most of the black money may be stored in the form of physical assets instead of cash. Thus, only a small portion of it may be countered through demonetization. However, it will greatly impact the fake or counterfeit currency through stringent checks on its circulation.Demonetization will also reduce the volume of black money activities and bring more transparency. It will benefit the nation’s economy in the long term.
India being a more cash-based economy, demonetization may impact it hard in the short term. However, this exercise can bring immeasurable benefits over long term.