The issues around demonetization are complex. In a recent CNBC interview with former RBI governor, Dr.Rangarajan, when asked by the anchor as to how these events will translate on the RBI’s Balance Sheet and the Government’s Balance Sheet, he replied that he ‘has to apply his mind’ on these issues. The question was regarding the reduction in fiscal deficit and windfall dividends that Government could receive due to currency demonetisation. Now, he wasn’t trying to be politically correct, since he answered many questions before this one. The issue is complex and he was simply admitting to that.
Subsequently, ex-RBI gov Dr.Subbarao too echoed similar doubts on the central bank’s ability to reap profits or transfer dividends when a currency is demonetized, since the guarantee and the promise to pay the denominated amount remains.
Let’s make a modest attempt at unravelling the recent demonetization phenomenon.
Firstly about statistics. In the earlier quarters when certain transactions were counted in the GDP figures and those transactions were mediated through fake currency can we then say that those GDP figures were overstated? The question can be posed differently. If the future GDP were to decline vis-a-vis previous periods because certain fake currency notes would then been extinguished, can we call such a GDP decline, a genuine decline? Shouldn’t we first restate previous year’s GDP data based on new information?
When fake currency comes into the system, the first-handlers of fake currency are the real beneficiaries. If you print a certain amount of fake currency at your home and go out to buy goods, then you are enormously benefitted. Since against the fake currency you printed you didn’t give up goods or render services but you pulled it out of thin air (barring the costs of printing).
But every subsequent transaction using fake currency is a legitimate transaction. The fake currency used in the subsequent transactions gain legitimacy as far as economics is concerned. The fake currency attains the status of a medium of exchange despite coming of inferior parentage. The medium of exchange function of a currency is simply its ease of handling and acceptability between people. That function doesn’t cease based on who issues the note. (In historical times, even horses were used as currency).
Now when the fake currency is de-legitimised, the final holder of those fake currencies is left holding the bag. And future circulation potential of this bundle of currency is killed. The final holders are the guilty manufacturers who are left with inventory of fake currency, along with their printing presses. Innocent individuals, who are left with some fake currency in the economic chain, will try to exchange these notes with the bank. Whether these are exchangeable with the banks is not known. We don’t have the statistics for all these figures. If one knew the quantum of fake currency one could guesstimate the GDP impact based on a velocity assumption.
It is difficult to quantify the amount of fake currency. The official and unofficial estimates differ vastly. While official figures have been put at Rs. 400 crore, one has to be sceptical about this data as the machinery behind producing fake currency is a State which is inimical towards the country. There is no reason why such a State would stop at that number. The unofficial estimates, shockingly, put fake currency as a few multiples of official currency.
Another type of currency is good currency but on which taxes are unpaid (black money). Now the question is what quantum of black money will circulate back into the system. Holders will now decide whether to reveal to the government the tracks leading to the creation of black money, in which case the government gets to know a great deal about the holder; or to simply let the black money rot into extinction. We don’t know the motivations of such individuals at an aggregate level. So we can’t model these figures.
Overall these events are an exercise in cleansing the statistics and economic machinery of the country.
GDP is bound to fall due to the destruction of economic capital (unaccounted or black money from the point of view of the Govt), played out in spurts over next few quarters. No one can predict the precise fall and timing with any reasonable approximation.
As and when these statistics come out in print, stock markets, the barometer of the economy, would fall.
Many commentators talk about the fall in consumption, due to reduced circulation of currency and the time lag for new notes to enter circulation. And that, these measures are positive for financial assets. I think they have got it slightly wrong.
We need to look at the big picture behind these measures. Demonetization is part of a game whose title is Wealth Re-Distribution which every centrist or centre-right government or political party wants to achieve. The tax revenues and the fiscal space the government earns through these measures will be re-distributed to the poor and the labour class.
The ones left holding the bag in the aftermath of the demonetization are the rich who own the primary factors of production. In strict economic terms these are owners of land and machinery
Is it all for the good?
Politically speaking, it will help win votes as the masses see divine retribution for the years of corruption, high inflation and the unfair system that it has endured. But it will also dislocate the workings of the primary factors of production. Despite the stigma attached to land and other large transactions (due to the black component) they were nevertheless performing a useful function. That is the creation of productive capacity in the economy. The impact of demonetization hits this segment the hardest.
India has become accustomed to an economic structure where the final-stages such as consumption sectors (consumers, retailers and dealers) are largely organised whereas first-stage processes such as land buying and selling, land redevelopment, construction, steel and others have remained unorganised, largely. Though the first-stage processes are mediated through unaccounted money, they nevertheless perform an important function. Here, demonetization leaves substantial destruction of wealth in its wake.
The ones whose bank accounts are subsequently filled with the wealth transfer, the labour class, are consumption prone. The monies would be spent in consumption activities as soon as the distribution hits their bank accounts.
For these reasons, demonetization is pro-consumption and anti-capital formation, at least in the short to medium term.
Note, I am not saying every capacity-enhancing production process will be jeopardised. Only that black money has a safer haven in Land which is the first-stage driver of economic activity. You kill black money you necessarily kill the circular flows of activities that are part of the primary production process.
Money spent in consumption activities, by the recipients as mentioned above, will work its way up the economic pyramid towards the first-stage production processes. However, much of which will be lost in taxes, which wasn’t the case earlier. Tax wedge is an inefficient portion of productive activity as we have learnt in Econ 101.
The primary factors of production will kick-start but only after a prolonged period of dislocation. And next time every penny will be accounted.
Private Capex revival was said to start around mid-2018. Now this is (again) postponed for a long time. Meanwhile, government Capex is an alternative. But the productivity of government Capex is much lower than private Capex.
Suffice to say now, consumption which is inflationary will dominate and this is negative for stock markets in the medium term.
It will also be negative in the long term if suitable adjustments to enhance the productive capacity of the country are not undertaken. Such as lower tax rates to compensate higher disclosures, removing regulatory impediments and enhancing ease of doing business in a greater scale and depth.
A substantial tax reduction for the salaried class who have assumed an asymmetric burden of national income taxes for many years could come as a big relief.
Broadly, a fiscal stimulus is what some commentators are calling for.
The Govt is also ready to target other illegal and underreported transactions – such as Benami property. The collateral damages will again be high. The more the government interferes and dislocates prevailing ways of economic processes the more damage it does to private market functioning.
Therefore, stock markets could see a decline as it adjusts to the actual GDP of the country. The potential GDP may take a hit as the country plays out the larger game of re-distribution. Consumption could edge higher if re-distribution turns larger than expected, resulting in lower savings and slowing down capital creation.
Those who say stocks will gain legitimacy immediately are simple selling their wares too hard. One needs to take caution before being egged on by social media messages from brokerage houses and others to invest in themes or stock portfolios
The larger shift that’s happening is wealth transfer and redistribution. In the long term the tax-to-GDP ratio may go up as the numerator is likely to increase with better compliance. Even in the medium turn, tax-to-GDP ratio could go up due to windfall tax collections (numerator) and lower GDP (denominator) due to lower economic activity.
Fiscal deficit may go down as some portion of currency extinguishment accrues to the Govt. If the RBI cannot transfer the reduction in liability to the govt, then we can assume that the central bank has gained monetary space as a result of demonetisation. This monetary space could drive capital goods sector through lower interest rates. Country’s external rating may be reviewed upwards which could result in some inflows.
The current events are positive for the Government and the RBI. It’s negative for stock markets – short to medium term – which has always benefitted from some amount of illegitimate currency. The news about removing long term capital gains exemption for penny stocks category isn’t being viewed kindly either.
Demonetization is a necessary pain that the country needs to go through before coming clean and fair on the other side.