Wednesday 22/11/2017

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India’s money experiment

Among the EM, India is one of the economies with a high growth potential. Its economy grew with 7.5% in 2016 and it is expected to grow at a similar pace this year. The overhanging risks for the Indian economy (a slowdown in china, fed hiking cycle) remain managed for now. Of course, policymakers still have enormous challenges ahead: India’s public infrastructure remains in a dire condition, it ranks low on ease of business conditions indicators and excessive red-tape and corruption are not helping in this regard. Furthermore, the global movement towards protectionism poses challenges for India’s future growth.

Demonetization

Indian policymakers have recognized some of these issues and addressed them with a series of domestic reforms, one of which was the long-awaited tax reform that was approved by the Indian parliament last summer. The Goods and Services Tax (GST) reform should lead to a simpler uniform tax rate that attracts investors and creates lower tax burdens for manufacturing firms and Indian consumers. A more controversial act was the demonetization measure taken last November. Effectively on November 8th, prime minister Modi announced that the two biggest banknotes of IND 500 (6.8 euro) and IND 1000 (13.6 euro) were scrapped after midnight. Policymakers claimed that the action would curtail the shadow economy and the use of illicit cash to fund illegal activity and terrorism.

A severe shock

Given that the two banknotes are good for around 85% of all cash in circulation, 90% of transactions are done in cash and the fact that the announcement was a complete surprise, the economy experienced a severe shock. The shortage of cash caused panic, confusion, long waiting queues at banks and hampered several aspects of economic activity in its aftermath. The PMI business confidence indices declined sharply from very upbeat levels in October to contraction territory towards the end of the year. Credit growth from commercial banks slumped to a three-decade low. While the long-term goal of curtailing the shadow economy and reducing cash in the economy is important, it is difficult to justify demonetization given the short-term damage to the economy the radical measure has caused.

Also in Europe

India’s money experiment has wider implications. It is not the only country that is experimenting with reducing cash in society. Last year, the ECB decided to discontinue production and issuance of €500 banknote on concerns that it could facilitate illicit activities, although it remains legal tender and will always retain its value. Therefore, the full effects of the demonetization experiment on the Indian economy will be analyzed around the world with much attention.