In the short term, demonetization has completely dampened the Indian economy.
On November 8, 2016, Indian Prime Minister Narendra Modi declared that the two highest denomination currency notes, INR 500 notes (USD 7.3) and INR 1000 notes (USD 14.6) (which represent 86 percent of all currency in circulation), would be forfeited from being legal tender. By midnight, these notes were demonetized and with that the Indian economy was thrown into chaos.
The aim behind this action was to curtail black money, tax evasion, counterfeiting and corruption. However, on account of poor execution, this policy has created havoc in the lives of the middle- and lower-income groups of the Indian economy, as well as significantly curtailing domestic consumption and disrupting contract laboring, a significant portion of the workforce in India, especially in the agricultural sector.
India is a cash-based economy. Bloomberg data shows the share of cash in the volume of consumer transactions is 98 percent (against 55 percent in the United States and 48 percent in the United Kingdom).1 The lower strata of the Indian economy relies heavily on cash to meet their day-to-day expenses. One of the immediate results of Modi's announcement was a mad scramble to exchange the old demonetized notes for new notes. Long lines began forming in front of ATMs and banks to exchange notes. Once individuals reached the front of the line, they encountered new hurdles. The government had not printed enough new currency notes prior to the announcement, and strict withdrawal limits were put in place. The new denomination - INR 2000 (USD 29.3) notes - was too high to be useful for most people. The design of the new notes prevented them from fitting into existing ATMs. All these factors have led to a liquidity crunch in the economy.
In a cash-strapped economy, daily wage workers cannot find employment because their employers do not have the resources to pay them. Small producers are cutting down on production because they do not have enough cash to purchase raw materials or pay their laborers. Local industries are also facing similar problems and have suspended work temporarily. Cash is also the primary mode of transaction in India's agricultural sector, which contributes 15 percent to India's total output.2 Farmers are now unable to purchase seeds and equipment for their winter harvests. Consumption has drastically reduced with the shortage in liquidity, especially consumption of nonessential items (such as entertainment). Additionally, with a decline in consumption, farmers are unloading their produce at a lower cost and suffering losses on account of unconsumed produce perishing. Those difficulties are also affecting the service, manufacturing and export-oriented sectors.
Around 82 people have reportedly died from cardiac arrest or committed suicide since the announcement of the demonetization policy.3 Hospitals have been turning away patients who do not have new bank notes to pay advance deposits. Families cannot buy food, and middle-class workers do not have cash to buy medicine.
These short-term effects of demonetization have significantly affected the middle- and lower-income groups of the Indian economy. The affluent, who were the supposed targets of this policy, seem to be unaffected because only a small portion of black money is actually stored in the form of cash. Usually, black money is kept in the form of physical assets, such as gold, land and buildings. Therefore, through this policy, the government has been able to address only the portion of black money held in the form of cash, limiting the effectiveness of the demonetization policy to combat black money, tax evasion and corruption.
At this stage, India risks its position as the fastest-growing economy. The Reserve Bank of India has reduced its forecast of the GDP growth rate for 2016-2017 from 7.6 percent to 7.1 percent.4 Bank deposits have increased significantly, as people are depositing liquid cash as savings so the banks will convert their old bank notes into new notes. This has decreased current interest rates in the short term, but these are not voluntary long-term savings. Once there are enough new notes in circulation, it is expected that individuals will resume withdrawing their savings, which will lead to an increase in interest rates in the long term.
In the short term, demonetization has completely dampened the Indian economy. With a complete loss of income, the policy has caused pain and suffering in the lives of the middle- and lower-income groups of the economy, even though the purpose of the policy was to be "pro poor." The policy has also hit hard small and medium-sized Indian companies in all sectors, some of which may not recover. However, in the long run, this policy could bring greater transparency and accountability in the supply chain, real estate transactions and payment channels in the economy, which would be a boost for long-term growth and foreign investment in the country. The real estate sector in particular could attract more foreign investors because of the demonetization policy and other regulatory reforms brought about in the past year. Similarly, the export sector could benefit in the long run with increased transparency and accountability.
Whether the long-term benefits of the demonetization policy will balance out the effects on the lower- and middle-income groups of the Indian economy is debatable. Even though the policy was backed with noble intent, poor planning and execution have caused suffering to many, making Indians question the integrity of this bold step of the Modi government.