Impact of Demonetization on Indian Economy

On November 8, when the whole world was waiting for the outcome of US presidential elections, Prime Minister Narendra Modi plays his master stroke by announcing demonetization of Rs.500 and Rs.1000 notes to restrain corruption, counterfeit currency, terrorism and black money.

The term demonetization is not new in India. The highest denomination note was of Rs 10,000 which was printed in 1938 and again in 1954 by the Reserve Bank of India and demonetized in January 1946 and again in January 1978 to curb the illegal use of high denomination currency which was used for corrupt deals in the country. Such demonetization did not have a big impact on the Indian economy since less than 5 percent of population in India had access to such notes and most banks never had such currency notes.

However, with the current demonetization, the common public and bankers are undoubtedly facing hardship since more than 85 percent of currency in circulation has been rendered illegal in one single stroke. Demonetization is surely encumbering the current economy and will continue to do so in the near term and will also impact India’s growth for the coming two quarters but will have positive long lasting effects.

One of the biggest benefits of demonetization is that it is going to drastically affect the corrupt practices. People having black money in cash will not be able to exchange much as they would be in a fear of getting penalised and prosecuted by the authorities. Enemies of our country which are involved in counterfeit currency and terrorism will not be able to continue it further for quite some time at least. Usually, black income is kept in the form of physical assets like gold, land, buildings etc. and only a small portion of black money is actually stored in the form of cash. Hence the amount of black money countered by demonetization depends upon the amount of black money held in the form of cash and it will be smaller than expected. But more than anything else, demonetization has a big propaganda effect. People are now very much convinced about the need to fight black income and such a nationwide awareness and urge will encourage government to come out with even strong measures.

Bank deposit in the short term may rise, but in the long term, its effect will come down. The savings with the banks are actually liquid cash people have stored and it is difficult to assume that such ready cash will be put into savings for a long term. They saved this money into banks to convert the old notes into new notes. These are not voluntary savings aimed to get interest. It will be converted into active liquidity by the people who save only when full-fledged new currency supply takes place. This means that new savings with banks is only short-term deposit. It is not essential that demonetization will produce big savings in the banking system in the medium term. Most of the savings are obtained by public sector banks which may reduce interest rate in the short/medium term. But they can't follow it in the long term. 

Prior to demonetization, India was an incredibly cash-centric economy. 95%of transactions were conducted through cash, 90% of vendors didn’t have card readers or the means of accepting electronic payments, 85% of workers were paid in cash, and almost half of the population didn’t even have bank accounts. After demonetization, cash transactions have reduced considerably and this move has proven to be a catalyst for consumption to be digitally driven and payments to go cashless. It is pleasing to see, since the demonetization drive, the number of smaller merchants such as tea stalls, grocery stores as well as consumers in rural and smaller cities embracing digital payments through mobile wallets, bank point-of-sale machines etc. But in order to make digital payments pervasive and sustainable, India not only needs to focus on continuing to roll out digital infrastructure, but also proactively educate its citizens on the long-term benefits of digital transactions.

Dr. Ashok Sharma

Associate Professor

Dept. of Management Studies