Monetary

&Fiscal Policy
Submitted By:
Mridul Maheshwari
Shagun Sharma
Kashish Prajapati
Winy Jain
Vishal Kumar Gupta
Rounak Khemka

PGP32175
PGP32176
PGP32177
PGP32178
PGP32181
PGP32199

Table of Contents
Monetary and Fiscal Policy in India ............................................................................................................. 2
Introduction ............................................................................................................................................... 2
Fiscal Policy .............................................................................................................................................. 2
Monetary Policy ........................................................................................................................................ 2
Fiscal Policy: present Indian context ............................................................................................................ 3
Monetary policy: current Indian context ....................................................................................................... 4
Inflation:.................................................................................................................................................... 5
Growth: ..................................................................................................................................................... 5
Balance of risks: ........................................................................................................................................ 6
Prices and costs: ........................................................................................................................................ 6
Demand and output: .................................................................................................................................. 6
Effect of Fiscal Policy:.................................................................................................................................. 8
Role of Monetary Policy to Ensure Economic Stability: Explained through IS-LM Curve Model ............. 9
DEMONETIZATION ................................................................................................................................. 11
The Announcement - Background: ......................................................................................................... 12
Intent ....................................................................................................................................................... 13
Impact: Positive ...................................................................................................................................... 13
Impact on MV= PY equation .................................................................................................................. 14
Impact: Negative ..................................................................................................................................... 15
Side Effects of Demonetization .............................................................................................................. 15
Economists' opinion ................................................................................................................................ 16
Sectoral Impact ....................................................................................................................................... 16
Real Estate .......................................................................................................................................... 16
Banking ............................................................................................................................................... 17
Auto..................................................................................................................................................... 17
Construction, Infrastructure and Cement ............................................................................................ 17
Consumer Durables and Retail ........................................................................................................... 17
Ecommerce ......................................................................................................................................... 18
References ................................................................................................................................................... 18

Monetary and Fiscal Policy in India

Introduction
There are two powerful tools that RBI use to steer our economy in the right direction: fiscal
and monetary policy. When used correctly, they can have similar results in both stimulating
our economy and slowing it down when it heats up. The ongoing debate is which one is more
effective in the long and short run.
Fiscal policy is when our government uses its spending and taxing powers to have an impact
on the economy. The combination and interaction of government expenditures and revenue
collection is a delicate balance that requires good timing and a little bit of luck to get it right.
The direct and indirect effects of fiscal policy can influence personal spending, capital
expenditure, exchange rates, deficit levels and even interest rates, which are usually
associated with monetary policy.

Fiscal Policy
Fiscal policy is often linked with Keynesianism, which derives its name from British
economist John Maynard Keynes. His major work, "The General Theory Of Employment,
Interest And Money," influenced new theories about how the economy works, and is still
studied today. He developed most of his theories during the Great Depression and Keynesian
theories have been used and misused over time, as they are a popular and are specifically
applied to mitigate economic downturns.
In a nutshell, Keynesian economic theories are based on the belief that proactive actions from
our government are the only way to steer the economy. This implies that the government
should use its powers to increase aggregate demand by increasing spending and creating an
easy money environment, which should stimulate the economy by creating jobs and
ultimately increasing prosperity.

Monetary Policy
Monetary can also be used to ignite or slow the economy but is controlled by the central bank,
the RBI with the ultimate goal of creating an easy money environment. Early Keynesians did
not believe that monetary policy had any long-lasting effects on the economy because
Banks have a choice to lend out the excess reserves they have on hand from lower interest
rates, they may just choose not to lend
Keynesians also believe that consumer demand for goods and services may not be related to
the cost of capital to obtain theses goods.

At different times in the economic cycle, this may or may not be true, but monetary policy has
proven to have some influence and impact on the economy and equity and fixed income
markets.
The RBI can also change the reserve requirements at banks thus directly increasing or
decreasing the supply of money. The RBI can also make changes in the discount rate which is
the tool that is constantly receiving media attention, forecasts, speculation and the world often
awaits the RBIs announcements as if any change would have an immediate impact on the
economy.
The battle has been hotly debated for decades and the answer is both. For example, to a
Keynesian promoting fiscal policy over a long period (25 years) of time, the economy will go
through multiple economic cycles. At the end of those cycles, the hard assets like
infrastructure such as buildings, bridges, roads and other long-life assets, will still be standing
and most likely be the result of some type of fiscal intervention. Over that same 25 years, the
Fed may have intervened hundreds of times using their tools and maybe only had success in
their goals some of the time. On the other hand, using just one method may not be the best
idea, because of the lag in fiscal policy as it filters into the economy. Monetary policy has
shown its effectiveness in slowing down an economy that is heating up at a faster than desired
pace (inflationary fears), but it has not had the same magnitude of change affect when it
comes to quickly inducing an economy to expand as money is eased, so its success is muted.

Fiscal Policy: present Indian context

Indian Constitution provides the overarching framework for the countrys fiscal
policy. India has a federal form of government with taxing powers and spending
responsibilities being divided between the central and the state governments
according to the Constitution. There is also a third tier of government at the local
level. Since the taxing abilities of the states are not necessarily commensurate with
their spending responsibilities, some of the centers revenues need to be assigned to
the state governments. To provide the basis for this assignment and give medium
term guidance on fiscal matters, the Constitution provides for the formation of a
Finance Commission (FC) every five years. Based on the report of the FC the central
taxes are devolved to the state governments. The Constitution also provides that for
every financial year, the government shall place before the legislature a statement of
its proposed taxing and spending provisions for legislative debate and approval. This
is referred to as the Budget. The central and the state governments each have their
own budgets.
Besides the annual budgetary process, since 1950, India has followed a system of
five-year plans for ensuring long-term economic objectives. This process is steered
by the Planning Commission for which there is no specific provision in the
Constitution. The main fiscal impact of the planning process is the division of

expenditures into plan and non-plan components. The plan components relate to
items dealing with long-term socioeconomic goals as determined by the ongoing
plan process. They often relate to specific schemes and projects. Furthermore, they
are usually routed through central ministries to state governments for achieving
certain desired objectives. These funds are generally in addition to the assignment of
central taxes as determined by the Finance Commissions. In some cases, the state
governments also contribute their own funds to the schemes. Non-plan expenditures
broadly relate to routine expenditures of the government for administration,
salaries, and the like.
Ensuring that the fiscal deficit remained around the budgeted 3.9% of GDP or 5.32
lakh crore has reinforced the credibility of government's commitment to fiscal
consolidation. To meet this ambitious target with growth of more than 7%,
government is using non-traditional ways such as strategic divestment, auction of
public resources such as spectrum and coal and collecting revenue in the form of
penalty on undisclosed income.
Agriculture is the most labor absorbing sector of the economy. In recent years, there
has been a decline in the dependence of population on agriculture partly because of
disguised unemployment. Some of the surplus labor in agriculture has moved to
either secondary or the tertiary sector. In the secondary sector, small scale
manufacturing is the most labor absorbing. In case of the tertiary sector, various new
services are now appearing like biotechnology, information technology and so on.
Current unemployment of India is 4.9% down from 5.2% in year 2013. To reduce
unemployment government is launching new schemes like startup India, standup
India and also strengthening employment guarantee scheme MNREGA. Government
has also kick started the program of Make in India to generate more jobs in
manufacturing sector and reducing reliance on agricultural sector.

Monetary policy: current Indian context

Key highlights:

Repo Rate has been reduced by 25 basis points from 6.50% to 6.25%
The reverse repo rate stands adjusted to 5.75 per cent
The marginal standing facility (MSF) rate and the Bank Rate set to 6.75 per cent
Cash Reserve Rate (CRR) at 4.00% (unchanged since 2013)
Statutory Liquidity Ratio (SLR) reduced to 20.75% from 1st October 2016

With the improvement of inflation rate, the target of 4% is yet to be achieved. The weak global
demand and slow private investments is another challenge for the growth although there is

increased consumption. Major points with respect to RBI report on monetary policy is explained
below:

Inflation:
Existing average inflation rate in 2016 is 5.48%. The expectation of households tend to
rise with the current development. The Reserve Banks survey of urban households
indicates a pick-up in their current perceptions and expectations of Inflation farther out.
Previously, respondents expected for the prices to rise with the rate more than current
rate.
In contrast, the producers are more optimistic towards their expectation of inflation
rates. Surveys indicate increase in proportion of respondents who expect rise in price of
inputs. The survey also indicates a decline in their expectations of higher selling prices.
By current reckoning, the pass-through of the goods and services tax (GST) will likely
commence from April 2017 and last for about 12-18 months. While the impact of the
GST on CPI Inflation would largely depend on the standard rate decided by the GST
Council. Almost 50 per cent of the CPI is expected to be exempt. GST implementation
might have one-off effects, which tend to dissipate after a year of its implementation

Growth:
The depressed private investment climate amidst subdued capacity utilisation and
corporate balance sheet deleveraging. Depressed global output and trade growth
lowered net exports. Several positive factors highlighted that could potentially lift growth,
including the governments start-up and other initiatives. The boost to household
consumption demand from the 7th Central Pay Commission (CPC) award, did not affect
costs much. Measures announced in the Union Budget 2016- 17 to transform the rural
sector, upbeat consumer confidence and the expected recovery in agriculture and allied
activities. Since then, some of these assumptions have materialised. Satisfactory
monsoon during the 2016 season, and the implementation of the 7th pay commission
were expected to provide a boost to consumption spending in both rural and urban. The
Reserve Banks survey found consumer optimism on the general economic outlook, but
somewhat less confidence on future income and employment. While private investment
activity remains sluggish, corporate business expectations remain upbeat on improving
prospects for production, capacity utilisation, employment and the availability of finance.
Over the medium-term, the implementation of the GST should boost business
confidence and investment, brightening the environment for an acceleration of growth.
Other initiatives such as steps to attract foreign direct investment in defence, civil
aviation, pharmaceuticals and broadcasting, measures to improve infrastructure, and the
enactment of the Insolvency and Bankruptcy Code and the Real Estate (Regulation and
Development) Act should also contribute to unlocking entrepreneurial energies and
growth impulses.

Balance of risks:

7th central pay commission award

Moderation in pulses inflation
Exchange rate movements
International crude oil prices
Global demand stagnation

Prices and costs:

Consumer price inflation was pushed up by a surge in the momentum of food inflation.
Input costs firmed up moderately for both farm and non-farm sectors alongside corporate
staff costs.
In the event, the momentum of the seasonal firming up of food prices that usually sets in
from April was much stronger than anticipated, especially in vegetables prices.
Moreover, occurring as it did on top of highly elevated prices of pulses, it imparted an
unusual upside to Inflation. In addition, international crude prices rose from a recent
trough to US$ 44 per barrel.
Consequently, headline CPI Inflation averaged higher at 5.7 per cent in Q1 of 2016-17,
deviating from the forecast of 5.3 per cent. With the rapid waning of these transient price
pressures in August, Inflation momentum collapsed. Inflation appears to be returning to
the April 2016 forecast path, albeit from some elevation. A one percentage point
deviation of food Inflation from its trajectory projected in the April MPR leads to 47 basis
points increase in headline Inflation in terms of the direct effect alone and this
perturbation could cause headline Inflation to diverge from its projected path for up to
four to six months, based on impulse responses in an unrestricted vector auto
regression (VAR) framework. This imparts a modest potential upside to the balance of
risks around the target of 5 per cent for Q4 of 2016-17.

Demand and output:

Aggregate demand slowed down in the first quarter of 2016-17, restrained by weak
investment, but consumption spending is gradually improving. Aggregate supply
conditions are poised to receive a strong boost from a reinvigoration of agriculture with
some support from services, but industrial activity remains subdued.
Economic activity lost some pace in the first half of 2016-17, relative to the preceding six
months and a year ago. A deeper moderation has been cushioned by robust public
spending. A retrenchment of investment has been underlying the slowdown; although
public investment has been stepped up, crowding-in effects on private investment are
not yet discernible. Private consumption spending has moderated somewhat, but a
revival of agricultural activity and incomes and a sizable upward revision in wages and
salaries in the public sector are set to boost it and regenerate growth impulses across
the economy in the rest of 2016-17 and in the next year. While the weakness in
domestic demand has sent imports into a prolonged contraction, the weakening global

economy and financial market turbulence constitute the biggest risks to net exports and
to overall economic activity, going forward.

To increase GDP growth, India is focusing on three-point strategy.

(i)
Capitalize on its strength in service sector, especially tech based services.
(ii)
Revive agriculture sector by introducing wider irrigation schemes and
reducing risk of crop failure.
(iii)
Giving larger push to manufacturing sector by promoting make in India
campaign.

Effect of Fiscal Policy:

Let us first explain how IS-LM model shows the effect of expansionary fiscal policy of
increase in Government expenditure on level of national income.
This is illustrated in Fig 1. Increase in Government expenditure which is of autonomous
nature raises aggregate demand for goods & services and thereby causes an outward shift in
IS curve, as is shown in Fig. 1 where increase in Government expenditure leads to the shift in
IS curve from IS1 to IS2.
Note that the horizontal distance between the two IS curves is equal to G x 1/1-MPC i.e. the
increase in national income equal to the horizontal distance EK that occurs in Keynes
multiplier model. However, in IS-LM model actual increase in national income is not equal to
EK caused by the working of Keynesian multiplier. This is because with the rightward shift in
IS curve rate of interest also rises which causes reduction in private investment. It will be seen
from Fig. 1 that, with the LM curve remaining unchanged, the new IS2 curve intersects LM
curve at point B. Thus, in IS-LM model with the increase in Government expenditure (G),
the equilibrium moves from point E to B and with this the rate of interest rises from r1 to r2
and income level from Y1 to Y2.
Income equal to CK has been wiped out because of rise in interest causing a decline in private
investment. Thus CK represents crowding-out effect of increase in government expenditure
Thus, IS-LM model shows that expansionary fiscal policy of increase in Government
expenditure raises both the level of income and rate of interest.

Fig 1: Expansionary Fiscal Policy: Impact of increase in Government Expenditure on interest

rate and Income
It is worth noting that in the IS-LM model increase in national income by Y1 Y2 in Fig. 1 is
less than EK which would occur in Keynes model. This is because Keynes in his simple
multiplier model assumes that investment is fixed and autonomous, whereas IS-LM model
takes into account the fall in private investment due to the rise in interest rate that takes place
with the increase in Government expenditure. That is, increase in Government expenditure
crowds out some private investment.
Likewise, it can be illustrated that the reduction in Government expenditure will cause a
leftward shift in the IS curve, and given the LM curve unchanged, will lead to the fall in both
rate of interest and level of income. It should be noted that Government often cuts expenditure
to control inflation in the economy.

Role of Monetary Policy to Ensure Economic Stability:

Explained through IS-LM Curve Model
Through making appropriate changes in monetary policy the Government can influence the
level of economic activity. Monetary policy may also be expansionary or contractionary
depending on the prevailing economic situation.
IS-LM model can be used to show the effect of expansionary and tight monetary policies. A
change in money supply causes a shift in the LM curve; expansion in money supply shifts it to
the right and decrease in money supply shifts it to the left.

Suppose the economy is in grip of recession, the Government (through its Central Bank)
adopts the expansionary monetary policy to lift the economy out of recession. Thus, it takes
measures to increase the money supply in the economy. The increase in money supply, state
of liquidity preference or demand for money remaining unchanged, will lead to the fall in rate
of interest.
At a lower interest there will be more investment by businessmen. More investment will cause
aggregate demand and income to rise. This implies that with expansion in money supply LM
curve will shift to the right as is shown in Fig. 2.
As a result, the economy will move from equilibrium point E to D and with this the rate of
interest will fall from r1 to r2 and national income will increase from Y1 to Y2. Thus, IS-LM
model shows that expansion in money supply lowers interest rate and raises income.
We have also indicated what is called monetary transmission mechanism, that is, how IS-LM
curve model shows the expansion in money supply leads to the increase in aggregate demand
for goods and services. We have thus seen that increase in money supply lowers the rate of
interest which then stimulates more investment demand. Increase in investment demand
through multiplier process leads to a greater increase in aggregate demand and national
income.

Fig 2: Effect of Expansion in Money Supply on Interest Rate and Income

If the economy suffers from inflation, the Government will like to check it. Then its Central
Bank should adopt tight or contractionary monetary policy. To control inflation the Central
Bank of a country can reduce money supply through open market operations by selling bonds

or government securities in the open market and in return gets currency funds from those who
buy the bonds. In this way liquidity in the banking system can be reduced.
To reduce money supply for fighting inflation the Central Bank can also raise cash reserve
ratio of the banks. The higher cash reserve ratio implies that the banks have to keep more cash
reserve with the Central Bank. As a result, the cash reserves with the banks fall which force
them to contract credit. With this money supply in the economy declines.
Thus, IS-LM model can be used to show that reduction in money supply will cause a leftward
shift in LM curve and will lead to the rise in interest rate and fall in the level of income. The
rise in interest rate which will cause reduction in investment demand and consumption
demand and help in controlling inflation. This is shown in Fig. 3.

Fig 3: Contractionary Monetary Policy to fight inflation

DEMONETIZATION
Demonetization affects the currency availability of every Indian citizen as it acts as a liquidity
shock. It means that people will not be able to transact with most used Rs. 500 and Rs. 1,000
notes for their day-to-day needs, causing a reduction in consumption, investment, production,
etc. The governments sudden decision is also causing inconvenience to all citizens, who are
queued up outside bank branches to deposit or exchange their old currency (while some are

finding ways to convert black money to white). However, the negative effects of the initiative
is expected to last for 2 quarters post which it will significantly dampen.

The Announcement - Background:

On November 8, 2016, Prime Minister Narendra Modi addressed the nation to communicate
the ban on high denomination Rs. 500 and Rs. 1,000 currency notes effective from 9th
November. Rs. 500 and Rs. 1000 notes, which account for 86% of currency in circulation,
ceased to be legal tender. Almost Rs. 14 lakh crore ($207 billion) was swept away at midnight
after the Prime Ministers announcement in an effort to curb black economy, corruption and
circulation of counterfeit notes.
Demonetization is not a new phenomenon in India as similar steps have been taken in the
past. In 1946, Rs. 1,000 and Rs. 10,000 notes were withdrawn to be replaced by Rs. 1,000, Rs.
5,000 and Rs. 10,000 notes. In an attempt to curb black money and address the menace of
counterfeit currency, Janta Party coalition government had demonetized Rs. 1,000, Rs. 5,000
and Rs. 10,000 notes in 1978. The latest endeavor to hurt the black economy, corruption and
fake currency was made by the Bhartia Janta Party on November 8, 2016 by demonetization
of Rs. 500 and Rs. 1,000 currency notes.
As can be seen from above, Indian economy has gone through couple of rounds of
demonetization in the past. November, 2016 announcement by the Prime Minister left 86% of
the currency in circulation worthless from 9th November. Measures were undertaken to
ensure withdrawal of the old currency, following were announced:

Old Rs. 500 and Rs. 1,000 notes can be deposited at any bank branch/post office up to
30th December, 2016, post which deposits will only be accepted at certain RBI
outlets. Valid identity proofs will also be required to deposit these notes; and,
Old notes can also be exchanged (by showing valid identity proof) up to the limit of
Rs. 4,000, which was revised to Rs. 4,500 and later to Rs. 2,000 till November 24.
This facility was stopped post 24th November and was limited to only 19 RBI
counters for a Rs. 2,000 limit.

These steps have resulted in huge chaos for citizens, esp. base of the pyramid population who
thrive on currency and a logistics logjam for banks. According to World Bank estimates, only
53% of the Indian population is part of the banking system of which many accounts have been
added as a part of the Jan Dhan Yojana. From an operational perspective, 33.33% of bank
branches are in Tier I and Tier II cities, which puts the rural population at a distinct
disadvantage.

Intent
Demonetization is a monetary policy tool, which has been used to address three problems in
one go viz., black money, corruption and counterfeit currency circulation.
When Narendra Modi led BJP government came to power in 2014, one of their top priority
agenda was addressing the black money issue in the country. There have been multiple
attempts in this direction from constituting a Special Investigation Team to income disclosure
measures announced later in the year.
The other intention of this bold move was to reduce corruption and misuse of currency for
political campaigns. According to RBIs Annual Report of 2015-16, cash circulation has gone
up to 15% vis--vis 10.7% in the last 3 years. This uncharacteristic spurt in currency
circulation raised some alarm bells. Demonetization was also an attempt to curb this misuse of
currency ahead of the state elections of 2017.
Finally, the three-stroke agenda was also targeted towards the rise in counterfeit currency and
terrorist financing. Most of the terror related activities are financed through cash of high
denominations. A ban on these notes will choke the finance channels for proliferation of
unwanted activities.
According to estimates,

Black economy is 25% of Indias GDP (~$500 billion) of which, only 5-6% exists in hard
cash and the remaining is stashed away in the form of gold, land, buildings or foreign
currency. Black economy represents legal or illegal production of goods and services
for which the government receives no tax; and,
According to a study conducted by the Indian Statistical Institute on behalf of NIA,
Rs. 400 crore of counterfeit or fake currency exists in the system which represents
0.028% of Rs. 14 lakh crore worth of currency demonetized.

Impact: Positive
Demonetization is the first step toward black money eradication from the country. Below
summarized are couple of positive effects of the move:

Tax Collection: With almost Rs. 6 lakh crore worth of accumulated deposits, tax
collection for the government will rise causing a decrease in budget deficit. The
government plans to levy a 30% tax with 200% penalty on unaccounted deposits, which
will also add to its coffers.
Financial Inclusion: Most of the cash, i.e. Rs 14 lakh crore worth of cash will go through
the banking channel and utilization of Jan Dhan accounts will also increase. As a part of
this initiative, more people might enter into the banking system.
Terrorism: Demonetization will stop access to high value currency by terrorists. As a
consequence of this move, the dire situation in Kashmir Valley owing to the death of
Burhan Wani has come to a halt. The massive stone pelting (mostly financed using Rs.

500 or Rs. 1,000 notes) had caused disruption of normal activities in the valley, which
was restored to normalcy 10 days after demonetization.
Fall in interest rates: Rise in deposits (almost Rs. 6 lakh crore deposited with banks) will
cause many banks to lower their interest rates. This will also cause cheap credit to be
available in the market. RBI shall be incentivized to decrease rates further given the
expected fall in inflation and increased liquidity in the financial system. However, given
that interest rates will go lower (5 to 6 percent), retail investors are likely to start shifting
their savings to other forms of high-yield investments, especially stocks/equity markets.
(Retail participation still remains low for Indian markets, even after the Modi government
came to power.
Bond yields: Given that fixed bond yields are expected to go lower, even investing in
bonds would be very attractive now (this is similar to when interest rates fell from 9 to 7
percent from 2013 to 15), from which one can expect a capital appreciation of 10 to 15%
in the near term, on top of the fixed interest
Digital transactions: Demonetization will also give a boost to digital transactions. Paytm,
Indias largest mobile payment platform has seen a 435% rise in overall traffic on its
platform since the announcement on 8th November.
Government Expenditure: The government has been spending on infrastructure and
housing schemes for the poor, which will become faster in the coming year because rise
in tax collections. This also give a boost to the construction industry, which might be
otherwise negatively impacted by the damping effect on private housing.

Impact on MV= PY equation

The quantity theory is based on one equation: MV = PY, where M denotes the quantity of
money in circulation, P is the price level, Y is GDP and V denotes the velocity which captures
the speed with which money circulates in the economy. The equation, based on the idea that
money is used to buy up goods and services in the economy, predicts that for a given velocity,
a fall in M would translate into a fall in nominal income which is PY.
While the quantity theory seems easy to implement, to use this equation to forecast the effect
of a monetary contraction on real GDP, however, one needs to make some assumptions
regarding the size of the fall in M, whether velocity will remain unchanged at all, and how
much of the change in M will be accommodated by a change in prices P rather than in Y. As
an example, under the assumption that 85% of the demonetised cash is exchanged for either
new notes or bank deposits, the resultant fall in M1 (sum of currency in circulation and
demand deposits with banks) over the months of November and December would be around
8%. Based on this and the fact that nominal monthly GDP is about Rs 11.5 trillion, the
quantity theory would predict that the loss in nominal GDP during these two months would be
around Rs. 1.8 trillion. Hence, nominal growth over the fiscal year (FY) 2016-17 would be
lower by Rs. 1.8 trillion. If we were expecting 7.5% real GDP growth over this fiscal year and
4% inflation (or an 11.5% nominal growth), then this output reduction due to demonetisation
would imply a 1.7 percentage-point reduction in nominal growth. As long as inflation remains
as expected, this would imply that real GDP growth for FY16 would be 1.7 percentage points
lower than expected.

The calculation above should make clear that there are a number of uncertainties in this
projection. The amount of demonetised cash that is returned could be higher or lower,
velocity of M1 could decline as people change their behaviour in response, inflation could
come in higher or lower, or M1 could fall less as the money multiplier itself rises due to a
decline in the cash to deposit ratio. Indeed, varying these assumptions, one could easily come
up with real GDP growth rate cuts for FY16 that vary from a low of 0.5% to a high of 3.5%.
One shouldnt be surprised if the cost ultimately comes in somewhere between 1.5 and 2% of
GDP growth. That is high.

Impact: Negative
The issues with demonetization could be characterized into two buckets; one inherent to the
effects of the demonetization scheme and the other one caused due to lack of proper
implementation.

Side Effects of Demonetization

47% population is not linked to the banking network. Around 300 million people lack
identification papers. Rural India is a 98 per cent cash economy. We are not a
European economy, we are an economy that is characterized by rural population and
middle income households;
Cash transactions amount to 80 per cent of total transactions. Informal Sector
accounts form 45% of GDP and 80% of employment;
Figures vary, but by most accounts, only 6 per cent or less of black money is parked in
cash. Rather they are converted into gold, real estate, foreign currency, bitcoins.
Experts predict that this might lead to a short term GDP loss of 1-2%. There are a lot
of perfectly legal, convenient bits of economic activity that are not being able to be
conducted right now. Both Moodys and Fitch predict that India may feel the impact
for several months. Duration of the slowdown triggered by the abrupt withdrawal of
most of Indias cash will depend on how fast it can be replaced. Potential crash in
some sectors may impact growth.
To hit the 60% mark (Rs9.0trn) of currency earlier in circulation, the government will
need to keep printing at this flat-out pace (3 shifts) until at least 20 March.
People have found a way around it. Black money hoarders find ways to divide their
hoard into many smaller pieces and get them remonetized again.
Focus could have been more on generation and not retention. For example, the
government could choose to evaluate the tax accounts of 8 lac individuals who get
huge income tax exemptions for agricultural income. This number has grown 3 times
over the past 5 years

Tax departments may use it as an excuse to harass people; Huge corruption in

taxation department as well; Expensive exercise for the Indian Economy; Over the
long term, this may lead to people losing confidence in the currency.
Political opposition to this move may delay GST implementation, which would be
another disruptive change in CY17.

Economists' opinion

Some 16 lakh crores would require to be infused into the economy in a matter of
days; Since the secrecy of the exercise couldnt be compromised, major partners like
RBI, Note Printing Press, Banks, ATMs, Security agencies, Logistics were grossly
underprepared.
Lot of flip flops in implementation. There was an exchange scheme of Rs 4500
eventually which was reduced to Rs 2000 and is now temporarily suspended; No
clear guidelines on preventing the same individual from exchanging cash multiple
times; Issues of farmers and weddings were not recognized earlier and still are
coming up with new guidelines; Government introduced a new method -- of marking
people who come to exchange notes with indelible ink.
The government failed to take into account the rural and backward areas of the
countries where banks and ATMs are still a far cry. With the government announcing
the decision at around 8 pm and the change happening at 12 am, it is very unlikely
that the news would have reached such areas in four hours.
ATMs were not calibrated for new notes; initially only Rs 100 notes were dispensed
and then single notes of Rs 2000 were getting dispensed which were difficult to
exchange;
The announcement was made at the height of the harvest season and the sowing of
the new crop, where transactions happen almost entirely in cash. It was also the peak
of the marriage season;

According to some estimates, about 1.5 crore marriages are to take place in the next few days,
and harried families are spending days standing in queues outside banks and ATMs. The rest
is in benami properties, gold and bullion, or abroad.

Issues with the overall logistics; Lack of currency notes; huge queues outside banks.

Sectoral Impact
Real Estate
As per estimates, 30-40% of demand in the housing sector is funded by black money.
Residential market to decline especially in unorganized markets. Luxury home buyers would
also be effected by liquidity crunch and loss of black money. Would result in lower prices as

developers try to protect their liquidity? Over the long term, the real estate prices will correct
and housing should become affordable leading to better growth.
Demonetization move will ensure that going forward, the sector will lose much of its historic
taint and become more transparent.

Banking
CASA accretion will shoot up in banks, especially PSU Banks. This is owing to the rush to
deposit cash in the banned denominations. However, certain part of the cash would be
transitionary but the overall impact should be positive.
Increase in CASA balance would result in decrease in cost of funds for banks. RBI would be
further incentivized to decrease rates further given the expected fall in inflation and increased
liquidity in the financial system. However, given that interest rates will go lower, retail
investors are likely to start shifting their savings to other forms of high-yield investments,
especially stocks/equity markets. NBFCs, microfinance and vehicle finance players may have
a short term negative impact as most of their collection happen through cash.

Auto
Near term demand across categories would be significantly impacted. Two wheeler segment
would be largely impacted because of the high proportions of transactions in cash. Demand
for four wheelers will have an impact based on down payments and consumer sentiment.
Given the funds crunch, demand for luxury, sedans and SUVs is likely to be impacted the
most.

Construction, Infrastructure and Cement

As they are dependent on real estate, demand would have a negative impact over the short
run. Cement demand to take a hit, given 70% of cement is consumed by housing. The move
on black money will likely result in demand destruction in organized real estate as well as
individual/rural house construction, which will get transmitted to cement demand in due
course.

Consumer Durables and Retail

Cash accounts for nearly 75-80% of the transactions and hence demand growth will face a
slow down because of liquidity crunch. In the short term, retailers may feel the pinch as
consumers, particularly those who prefer to pay in cash would have a liquidity crunch. In the
long run though, movement towards a cashless economy would be positive for organized
retailers

Ecommerce
Huge positive effect as people move to cashless banking services like e wallets, cards, net
banking. While the cash deliveries would be impacted in the short term, the long term impact
is highly positive as people would start moving away from brick and mortar stores.
Sectors with high debt and high need of growth capex will see a decline in borrowing costs,
which will have a direct impact on the bottom line:

Metals (also driven by the global rally in commodity prices)

Telecom
Infrastructure

References

https://rbi.org.in/Scripts/PublicationsView.aspx?id=17385

http://www.thehindubusinessline.com/companies/announcements/others/update-onimpact-of-demonetization-on-the-company/article9411684.ece

http://www.thehindubusinessline.com/companies/announcements/others/update-oncurrent-impact-of-demonetization/article9347750.ece

orb.essex.ac.uk/ec/ec201/lecture_notes/ec201lecture7-8.pdf

http://www.thehindu.com/opinion/lead/Full-marks-on-fiscal-deficit/article14142151.ece

http://www.investopedia.com/articles/economics/12/fiscal-or-monetary-policy.asp