5 Things We Missed Out In Modi’s Demonetization Logic…

Since the government decided to demonetize the currency of denomination 1000 and 500 on November 08th, there has been a lot of ink spilt on the merits and demerits of the demonetization move. Industry is up in arms against the liquidity crunch but is scared to speak too much against the black money drive. Journalists have typically taken extreme positions without understanding the nuances of the demonetization debate.

The key issue that most are missing is that the goalpost of demonetization is not what many would like to believe. The immediate intent of the demonetization exercise is not to flush out black money, although that will be the eventual impact. Here are 5 key things we may have missed out in the demonetization logic…

01. The immediate intent was to create a liquidity crunch

This may sound a little weird! Why would the man at the helm of an economy growing at 7.5% want to risk a liquidity crunch? Would it not push the economy back? To understand this point, let us look at the converse of the argument. If sucking out liquidity was to slow the economy then infusing liquidity would spur growth. Sounds logical, but that has hardly been the global experience over the last 8 years. The EU and Japan have been infusing billions of dollars of liquidity each month but growth has hardly picked up in the last 8 years. Same is the case with the US, which has finally veered around to raising interest rates. That is exactly why the government has issued 2000 denomination notes but gone slow on 500 denomination notes. The huge value gap between 2000 and 100 notes will ensure that the liquidity crunch continues. At the end of the day, the government has only taken away the cash liquidity. The bank liquidity is still intact.

02. This was the best way to curtail demand pull inflation…

The CPI inflation at 3.63% in November was not just about control over food inflation. It was about a crunch on loose cash post demonetization. Inflation is likely to stay weak in the coming months as the government is unlikely to print fresh notes to the extent of notes demonetized. The problem with too much cash floating around is that nobody bothers about the price they pay as long as cash is floating around in the system. Walk into any retail vegetable market today and the impact on prices is starkly visible. Prices have come down drastically. If India needs to grow in the long run, then inflation needs to be contained; and that is not possible unless the floating cash is reduced.

03. Push the unorganized sector into the organized mode…

This was one of the key intents of the demonetization exercise. And by early indications, it has been a roaring success. Walk into any small shop today and it very likely that they have a POS machine where you can swipe your card and it is almost certain that you can use an E-wallet like Paytm to pay for even the smallest of purchases. In one move, the government will move millions of small traders and entrepreneurs into the financial mainstream. The moment they come into the digital mainstream, there will be a complete audit trail of transactions. That means your friendly neighbourhood grocer will also end up paying at least the bare minimum tax on his presumptive profit of 8% (likely 6%) of revenues. This will not just be a huge push for the tax base but also it will be fair to the organized segment.

04. Demonetization was the best way to snap the asset inflation bubble…

OK, this is a slightly more convoluted topic! How does asset inflation happen? When there is too much money chasing a handful of assets, then the relationship between value and price tends to get divorced. Let us look at the Indian example. Between 2012 and 2016, Sensex earnings have hardly grown. Whatever little growth in earnings we have seen is purely due to the impact of cheap oil. During the same period, the Nifty is up almost 2-fold. The answer lies in too much money chasing a handful of Indian stocks. Obviously, most Indian stocks are quoting at steep valuations. Look at real estate! The largest markets like Mumbai, NCR and Bengaluru are sitting on unprecedented quantities of unsold inventory. Yet, there is hardly any worthwhile fall in prices. Again, it has been a case of too much easy liquidity floating in the system. With the screws on cash being tightened, all that should change.

05. Finally, piecing the puzzle together for addressing black money…

Remember, controlling black money was never the goal post for the demonetization exercise. The four key goal posts have been highlighted above viz. Liquidity Crunch, Inflation Control, Organizing Business and Asset Deflation. So does that mean that demonetization will not impact black money?

The good news is that it eventually will. There are typically 3 stages to black money viz. Creation of Black money, Perpetuating Black Money and Storing Black Money. Let us look at the first stage. Black money gets created when your shopkeeper does not show his income or a large business house over-invoices exports or when you just gratify an official with cash for a favour done. Digitization should largely address this issue by creating a clear and enduring audit trail. Secondly, we come to the issue of perpetuating black money. It is impossible to perpetuate black money unless cash is available in abundance. Whether you want to purchase property in cash or pay lease rentals in cash, you need availability of cash. Believe me, this restriction on cash will continue long after December 30th and have no illusions about it. Without cash available freely, perpetuation of black money will be substantially curtailed.

Lastly, we come to the issue of storing black money. Typically, black money is stored in gold, property or in foreign assets with a small portion stored in raw cash. Black money stored in property will be hit by the asset deflation and automatically come into the mainstream. Investors are increasingly seeing the benefits of demonetizing their gold holdings and that trend will pick up further as audit trails getting stronger. Foreign black money will be slightly more complex, but that will come through a mix of amnesty schemes and lower taxes.

The crux of the matter is that one should not get carried away by the link between demonetization and black money. That is not the intent of the government. Don’t complain about the liquidity shortfall in the economy because that is entirely intentional. Don’t complain about falling asset prices; that is also intentional. Of course, the entire exercise will be eventually beneficial for the Indian economy. That could be the good news and also reason to celebrate!

Source - Harihar T S on linkedin