India Tax Insights – ninth edition

Dissecting demonetization: balancing losses and gains

Dr. DK Srivastava, Chief Policy Advisor, EY India

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EY - Dr. DK Srivastava India’s November 8 demonetization has led to three inter-related but distinct policy challenges: (a) containing its contractionary effects, compounded by a demand slowdown, (b) ensuring a lasting blow on the black economy and (c) uplifting digitization of transactions.

Demonetization and re-monetization: the crippling imbalance

Demonetization happened in one stroke; however, re-monetization is constrained by the RBI’s capacity to print and supply new currency, resulting in a severe cash crunch. According to available information from RBI1 , by 27 November 2016, 55.4% (by value) of the demonetized money had come back: only 16.4% (by value) through re-monetization and 39% (by value) through additional bank deposits value. This figure increased to 78% by 7 December 20162. We expect that the cumulative percentage of re-monetization will progressively increase and the cumulative share of additional bank deposits will fall after reaching a peak. These two trends are depicted in Charts 1 and 2. By the last week of February 2017, the cumulative re-monetization should exceed 75%, which may end the period of severe cash crunch.

EY - Demonetization and re-monetization: the crippling imbalance

Contractionary effects: short-term growth impact

The cash crunch resulted in a sudden contraction of demand, adversely affecting growth and employment in sectors with a relatively high share of unorganized activities, such as agriculture, construction and some service sectors.

Table 1 gives a summary of assessments undertaken by the RBI and selected rating agencies on the impact of demonetization on GDP growth for FY17. Many of the recent assessments have revised down India’s FY17 GDP growth down to close to 7%.

Table 1: FY17 GDP growth estimates

Entity/rating agency Post demonetization Previous Percent point change Percent of previous estimate
The RBI 7.1 7.6 0.5 6.6
Care Ratings 7.6 7.8 0.2 2.6
ICRA 7.5 7.9 0.4 5.1
ICICI Securities 7.4 7.8 0.4 5.1
Morgan Stanley 7.3 7.7 0.4 5.2
Fitch 6.9 7.4 0.5 6.8
Goldman Sachs 6.8 7.9 1.1 13.9
Emkay Global 6.5 7.4 0.9 12.2
Ambit Capital 3.5 6.8 3.3 48.5

Source: RBI’s Monetary Policy Review (7th December 2016) and Mint Research (24th and 30th November 2016)

Ensuring long-run growth: supplementary policy support

Contraction in money supply may result in a fall in GDP growth over the long run if the currency-to-money supply ratio remains constant. Furthermore, the contractionary effect may accentuate if investment demand remains weak. Recently released data shows that for three quarters in a row, gross fixed capital formation has contracted with an increasing magnitude. We expect that with digitization, the currency-to-money supply ratio may fall, the money multiplier may increase and its long-term contractionary impact may be neutralized.

Table 2: RBI assets and liabilities (INR billion)

Liabilities Assets
Notes issued 13,072.5 Foreign currency assets 23,193.0
Deposits 8,961.0 Gold coin and bullion 1,367.9
Other liabilities 9,254.9 Rupee securities including Treasury bills 7,563.1
    Loans and advances 555.5
    Bills purchased and discounted 0.0
    Other assets 109.6
    Investment 23.2
Total liabilities 31,288.4 Total assets 32,812.5
    Excess assets 1,524.1
    FY17 GDP 1,50,650.1
    Excess assets as a percent of GDP 1.0

Source (Basic Data): RBI and EY Estimates (As on 11 November 2016)

This effort can be strengthened through a fiscal stimulus financed partly by a fiscal windfall resulting from extinguished currency, which may amount to about 1% of GDP, and partly through increased tax revenues. The former will require a rebalancing of the RBI’s assets and liabilities (Table 2). Further stimulus may come from reduction in interest rates facilitated by the surge in bank deposits.  

Combating the black economy

For a tangible dent on the black economy, supplementary policy interventions would include reduction in stamp duty rates, reduction and simplification of tax rates and tax codes relating to both direct and indirect taxes, effective and transparent provisions for financing of elections and an effective penalty regime concerning proven cases of black money generation. Exchange of information between India and the countries that serve as tax havens and complete abolition of “benami” property registration would provide sharper teeth to combat the menace of black economy.

Strengthening digitization

The Central Government is making a sustained effort to uplift the extent of digitization of transactions, particularly in rural areas and the informal sectors. In this context, the focus is on five main digital platforms: USSD (unstructured supplementary service data), UPI (unified payment interface), debit and credit cards at point of sale, PPI (prepaid payment instruments) and mobile banking. In December 2016, these platforms, except mobile banking (which has grown by 4% in value terms), have shown significant growth in value terms (598%, 419%, 31% and 45%, respectively) over November 2016 (extrapolating the data from the first 16 days of December for the full month)3. However, the weight of these platforms in total digital transactions is still small (less than 2%). To ensure success on the digitization front, these trends will have to be sustained for a long period.


1RBI Press Release (28 November 2016) “Withdrawal of Legal Tender status of banknotes of Rs. 500 and Rs. 1000: Activity at Banks during November 10-27, 2016”
2RBI Monetary Policy Press Meet dated 7 December 2016
3RBI Data on Electronic Payment Systems - Representative Data (Updated as on 17 December, 2016) https://rbidocs.rbi.org.in/rdocs/content/docs/EPS03122016_AN.xls (website accessed on 19 December 2016)

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