Predicting the immediate post-demonetization fallouts: How should the government respond

We are witnessing an event that has no parallel (although some past experiences of Soviet Russia, Nigeria or in a small scale in India exists) and the mammoth scale of the Indian demonetization move must be attracting economists the world over to make estimations, hypothesis and counter points.

First of all we have a commodity like currency in short supply. We think it is temporary and once the printing presses bring back parity, the whole saga will be ending on a good note.

I would have been the happiest person, if this was the case. Unfortunately it is not the case. I am not saying that it would take quite some time to bring back parity in the supply and demand; I am saying the parity has other potential challenges.

There is a big block of currency that is permanently lost, let me call this “bad money”. It took with it economic activities as well.

We made a fresh start after the announcement with let’s say zero base of “good money” in public hands. To restore the previous base of good money held by public it would mean that the sum total of total money in circulation have to turnaround several times to be able to reach the previous level; the same level of output and employment can only achieve that, but is it a good assumption to make?

This is a monumental and almost near-impossible task, as there are several intermediaries including the Government who receive and give money and is a part of this process. It includes taxes in various forms that the government must receive in form of revenue and it would be naïve to imagine that all collections would remain at the same level as before.

It would not as all business transactions that were being done with cash are not continuing at the same pace. These businesses, no matter how small they are, actually involve indirect taxes.

While these small businesses and traders may not be paying income taxes, the underlying goods and services involve indirect taxes which gets collected by the government like sales tax, excise, import duties, etc. If all these traded products get bought and sold in less numbers, these tax collections are bound to suffer.

So we have a stream of payments getting impacted right from day one.

Let me turn my attention to the most likely behavior of the common man. He would be the one standing in the queue, as poor consumers of cash would not mind standing in the queue longer with low marginal utility of time. He would definitely postpone consumption to improve his marginal utility.

What kind of consumption would be postponed is the question; all discretionary ones of course for the common man. One can make a good list of that.

Let me now turn to the very basics of money circulation.

When a transaction happens in any traded goods or services with cash, at the end of the day, no one would like to keep cash in excess of his running needs and the balance goes back to the bank. Therefore the banks remain the biggest repository of cash-backs.  

Now this changes a little bit for the common man. He would like to keep something more with him now given his trials and tribulations of receiving money from the counters or ATMs. This can only happen when he postpones his consumption. But the moot point is that he is not transacting in cash which would have eventually returned to the bank as excess.

The normal circulation of money is disturbed so it is most likely that the first several months would see less money getting back to the bank. With the incremental CRR and other restrictions being put by the Reserve Bank, the obvious fall out would be that banks would not be able to estimate how much would be actually getting parked as excess.

In other words the new normal of fresh deposits of cash-backs would be very difficult to estimate; most likely they would be starting off at very low levels from the previous benchmarks and slowly inching up as the economic activities get back to normal levels.

India’s cash to GDP is around 12% and this is a lot but the important point we have missed so far is that it is the uninformed and unprepared poor who hold most of this and traders who are part of this same group in all the transactions. With government collections getting impacted the cycle gets an additional shock.

No wonder nations including U.S. who have the distinction of having the highest counterfeit currency in circulation never could venture into the act of demonetization although the cash currency to GDP ratio is much smaller.

An experiment of this size has many other unintended consequences; we would start to see them as they unwind.

The government on the other hand must get back to the role of communicating and communicating alone, so that the trust is restored in the common man that we have the same monetary system working for the economy and the people as it was before the shock therapy happened.

Restoring this trust would need a different communication strategy that is based on a language that the poorest of the poor understand.