Demonetisation: Deep Consolidation In Informal Sector Inevitable, Dragging Growth
The note ban is one of a larger pool of measures aimed at more formalisation, write DBS Bank’s Taimur Baig and Radhika Rao.
A year after the government of India scrapped high denomination currency notes, a wide range of indicators suggests the economy is still coming to terms with it. While the initial scene of long lines to exchange notes disappeared within a month or so, the shock measure left a rather lasting impact on informal economic activities, bank deposits, and digital transactions.
We see demonetisation as one of many measures taken in recent years, by the authorities, to nudge Indians toward formalised economic activities — an economy where proceeds from activities can be tracked is one where the tax base is bound to expand and malfeasance is harder to hide. Other measures might not have been as dramatic as demonetisation, but targeted cash subsidies, financial inclusion, e-governance, universal ID, and the latest, registration of businesses under the Goods and Services Tax, all aim to bring Indians’ income-generating activities out in the open.
In an economy where 90 percent of employment and over 50 percent of gross domestic product is derived from informal activities, this is bound to be a highly disruptive process.
Without adequate social safety net provisions, the inevitable rise in the cost of operating in the formal economy (entailing registration, tax compliance, and regulatory obligations), will likely compel many informal businesses to either restructure or perish.
Since wage and income data from India’s informal sector is not well covered, the inevitable adjustment forced by formalisation may not show up in most reported data. We, therefore, look for corroborative evidence on how much adjustment has already taken place, and what is left.
Considering that the economy is undergoing a multitude of reforms, it is sometimes difficult to distinguish the impact of demonetisation from the rest. For example, GST stipulations, introduced in July, must have had some consequences for margin, profitability, and activity.
With that caveat in mind, the data on two-wheeler sales, demand for public works, and credit to small and medium enterprises (SMEs) are perhaps the best we have in understanding how the currency swap program has shaped the economy over the past year. We are more comfortable analysing the impact on the financial sector, given the abundance of data.
India’s money markets and financial system reacted instantly to demonetisation. Bank deposits surged, leading to a spike in reported domestic liquidity, which overwhelmed the Reserve Bank of India’s absorption efforts, pushing the rate curve lower and prompting banks to trim deposit/lending rates.
Trends have since improved, as the RBI removed cash withdrawal limits by February-March 2017 and stepped up the supply of new notes.
Concurrently, strong deposit growth turned the liquidity balance from neutral in October 2016 to a strong surplus by March 2017. To correct this imbalance, the central bank raised the reverse repo rate in April 2017 and resorted to additional liquidity absorption measures. These, however, came at a cost.
RBI’s earnings took a hit due to a jump in costs associated with demonetisation and liquidity-absorption measures in FY17. Total income was down 24 percent, while expenditure surged. Costs associated with currency printing rose 130 percent in FY17, as four-fifth of the monies in circulation had to be replaced. These led to a halving in RBI dividends paid to the government, hurting the latter’s non-tax revenues this year.
Subsequently, liquidity conditions have tightened as the surplus fell below Rs 1 lakh crore and absorption efforts might continue till the balance is back to neutral.
Impact on the real economy was broad-based and prolonged, but with varying intensities across sectors. Cash-dependent service sectors, like transportation, logistics, real estate, retail etc. took a greater hit than the larger/listed entities. Rural demand was depressed, given its cash-intensive nature, while the switch to digital payment modes helped mitigate the impact on urban demand. The pain was likely most acute in the informal sector, data for which is unfortunately patchy.
Looking ahead, while the bulk of the note ban-driven pain is likely behind us, households and businesses are still to return to normalcy. This adjustment period was interrupted by the concurrent implementation of GST. Recovery in the informal activity is likely to be delayed, given the pain inflicted by two big-ticket changes within a short period of time. We gauged the initiative’s impact across three indicators, two-wheeler sales (crash, followed by a fairly quick recovery), demand for public works (still high), and credit to SMEs (still weak).
The effectiveness of the demonetisation exercise was mixed. The Economic Survey cited three markers which help determine the success or effectiveness of the demonetisation exercise:
- Changes in the use of digital payment methods.
- A decline in the cash-to-GDP ratio.
- Expansion of the tax base, and
- Addressing the black/unaccounted money problem.
With the usage of digital payment modes moderating from the post-demonetisation surge, we believe that the shock-and-awe effect of the demonetisation initiative has pushed users towards digitalisation.
Although to retain the momentum, supportive efforts – improving the digital architecture/backbone, cyber-security framework, developing Aadhaar adoption, ensuring internet and telephony connectivity, financial inclusion efforts, and better investor education – are equally necessary.
Secondly, the cash-to-GDP ratio has eased, suggesting a reduction in hard-currency stock held by residents and parked as bank deposits. Next, anecdotal trends suggest that the tax base has widened, albeit a more important benefit in mind is whether collections have also improved in lockstep. Finally, on the gauge of whether the measure helped curb the usage of black/unaccounted money. As we write, the official count of returned notes to the commercial banks/RBI is pending, but the RBI’s FY17 Annual Report provided some insights.
For a more meaningful change, we believe that the push to arrest the usage and circulation of black/unaccounted money requires a broader cohesive framework to improve checks and balances in the system.
Demonetisation marks a step in this direction, with transactional data trails (through information on large deposits, tax liabilities, income records etc) likely to provide useful inputs for the tax and legal departments. Benefits due to higher due diligence, a wider tax net through income declaration schemes, and discouraging cash transactions were more palpable in the short term.
This includes pushing forth the biometric identification scheme, tighter regulatory and legal checks, transparency in tax transactions, monitoring money held overseas, among others. We are convinced that as more individuals and businesses join the formal sector, it would help broaden the tax base, reduce illicit transactions, and create a more enabling environment for regulated activities. Ultimately, this will provide for worker protection, a bigger revenue base for the government to invest, and a more level playing field among businesses. But, in the near term, a deep consolidation in the informal sector appears inevitable. This is bound to remain a drag on growth in the coming quarters.
Taimur Baig is Chief Economist and Managing Director; and Radhika Rao is Economist at DBS Bank.
The views expressed here are those of the author’s and do not necessarily represent the views of Bloomberg Quint or its editorial team.