From a purely political perspective, Prime Minister Narendra Modi's decision to demonetise ₹1,000 and ₹500 notes is a masterstroke. Reason: he has been under political attack for not bringing back the black money stashed abroad, something he promised to do when campaigning for the last Lok Sabha elections.
His scheme to obtain voluntary declarations on illegal assets held abroad flopped, garnering a mere ₹4,000-and-odd crore, and 60% of that in taxes. His domestic black money scheme, which closed last September, fared better, having enticed more than ₹65,000 crore. Of this 45% will come in as tax revenue. But nowhere near enough for him to claim visible success.
What Modi needed was something that would be visible to the aam aadmi, and this is what demonetisation achieves. At one stroke, everyone who has ever held a ₹500 note in his hands (or preserved on in her cupboard) will get to know Modi is serious about black money. That is the political impact of demonetisation, the only second such effort in living memory. The last one happened in 1978 during the Morarji Desai government.
The demonetisation demonstrably does what Modi's previous efforts didn't: it hurts people who are supposed to be hoarding black money, thus pandering to the aam aadmi's sense of schadenfreude, a perverse need to feel that the rich are being taken to the cleaners too.
There is also another political benefit Modi gets from this move: black money is the currency of election financing. By striking at these hoards just before the next round of state assembly elections, including the all-important state of Uttar Pradesh, Modi has not only put opposition parties in cash trouble but also made it difficult for them to accuse him of being soft on the rich. He has got them on the defensive.
And thirdly, of course, there is the side-benefit: socking it to the Pakistani Deep State, which has been at the forefront of pushing fake currency into the Indian market. This money is often used to finance terrorism in India. Demonetisation is an effective follow-up to the surgical strikes that left the Pakistani army seeking legitimacy at a time when its chief is due for retirement. Enabling big ticket terrorism on Indian soil when one way of financing it has been yanked from under your feet is tough. Modi has choked the business of terror financing for a while.
Over-leveraged companies have no option but to rely even more on formal bank finance – something that is not possible when banks are nursing bad loans. The pressure on black money cash hoards will slow down the recovery in corporate turnarounds.
But there is a price to pay. A big price on the economic front.
#1: The timing is inconvenient. At a time when industry is struggling to get the investment cycle going, crimping the supply of cash – even illegitimate cash – makes life more difficult. Let's be clear why this is so. This is not the first time India Inc has over-borrowed and gotten itself into trouble. In the past, not only did government help cronies by rescheduling loans, but promoters could also funnel black money indirectly into their companies covertly. This can be done by over-invoicing exports or under-invoicing imports, or by sending money out through the hawala route and bringing it back as equity investment. This money could have come through the Mauritius route, or even as informal loans. But when cash disappears, the hawala market goes into a tailspin. Over-leveraged companies have no option but to rely even more on formal bank finance – something that is not possible when banks are nursing bad loans. The pressure on black money cash hoards will slow down the recovery in corporate turnarounds.
#2: The consumption cycle will weaken. Tax-evaded money is high-power money. When it is spent, whether in elections or for conspicuous consumption by businessmen and politicians, it feeds through as consumer demand at various points of time. This kick from high-power money will now go missing. The consumption story will ride on only one engine, the one driven by Seventh Pay Commission payments to government staff and OROP.
#3: Don't rule out retail disruptions. Cash is the preferred way of settling payments at the kirana store, for paying kaali-peeli taxies and autos, to pay domestic workers and drivers. As cash will be in short supply for a while – a shortage that will not be remedied by exchanging the old notes for ₹2,000 notes – daily transactions will be impacted. This could lead to angst and irritation for the aam aadmi, and will need to be addressed quickly by flooding the markets with new currency notes. The middle classes and the rich will have fewer problems, as they can use e-wallets, mobile payments and electronic funds transfers to manage their inflows and outflows. Maybe this is a good time to push cash into Jan Dhan accounts and trigger a greater shift to mobile and electronic payments. But that will take some doing.
#4: With cash now turning risky for the storage of illegal wealth, real estate and gold will become more attractive. Gold, given its anonymity and relative portability, could become the preferred vehicle for black money. Gold December futures spiked on Wednesday by 1.6% to over ₹30,300. But real estate is unlikely to pick up, unless the assault on cash forces them to cut property prices, which can spur a demand revival.
#5: The stock markets have reacted badly – not only to the demonetisation, but also to the Donald Trump victory in the US presidential elections. With the Mauritius route being grandfathered, and with participatory notes losing some of their lustre with increasingly Sebi tightening rules, stocks have only two sources of liquidity – foreign investors and domestic mutual funds and institutions. Luckily this is happening, with the Employees Provident Fund Organisation allowed to invest upto 10% of its corpus in stocks (indirectly, through exchange traded funds) and steady inflows into equity mutual funds (through SIPs) of around ₹3,000 crore per month. But in the short run, cash tightness may force promoters and businessmen to sell stocks to raise money, and the markets will face some headwinds.
#6: If the goods and service tax (GST) is implemented from the first half of 2017-18, cash will be further crunched as indirect tax payments will spike and evasion will be difficult. This can lead to some cost-push inflation, leading to consumer resistance and a denting of sales and profits in the short run. A squeeze in cash liquidity due to demonetisation will further dent consumer confidence.
Demonetisation is a good move to squeeze out black money, but it is coming at the wrong time. Achche din may be delayed a bit more.