India’s demonetisation one year on: Damaging GDP or driving cultural change?

It has been one year since India’s Prime Minister Narendra Modi unveiled his surprise demonetisation initiative. The shock move saw 90 per cent of the value of notes in circulation demonetised in a bid to clamp down on ill-gotten wealth by rendering those storing illicit cash unable to declare it.

Jorry Rask Nøddekær is manager of the Nordea 1 – Emerging Starts Equity fund

I was in India when the Modi government made its surprise demonetisation announcement last November, which was quite a surreal experience. Removing 500 and 1000 rupee notes from circulation almost overnight was one of the wildest initiatives I have ever seen a politician take – remarkable for such a large economy.

While many people have been focused on the shorter-term impacts of this action, we believe it is important to view it through a much longer-term lens. This move allows India to operate in a more structured way and bring the ordinary person into the formal economy. We believe this initiative – as well as additional reform efforts, such as the recently introduced GST – will reap major rewards for India over a five to 10-year time horizon.

These actions have also sent a signal to India and to the rest of the world that Prime Minister Modi is for real. He does not fear being held hostage by other politicians or any special interest groups. Modi is passionate about reforming India and if he truly believes in something he is willing to take swift and decisive action. He is unlike any politician we have seen in India for some time.

Simon Finch is manager of the Ashburton India Equity Opportunities fund

Following the demonetisation announcement of a year ago, it was hotly anticipated that, once the ATMs were replenished with new notes, virtually all of the hurriedly banked money would once again find itself under the mattresses of Indians across the country.

However, a significant cultural shift has occurred, with around 40 per cent of those deposits now retained within the banking system. The change is expected to be sustainable and is one driving the Indian equity markets upwards, providing liquidity to the $3trn market.

A nation of traders and entrepreneurs, the Indian population is taking a growing interest in the domestic stock market. Previously idle money is now being invested in the local market, predominantly through the use of mutual funds and other savings vehicles.

The lion’s share of investment into Indian equities during 2017 has come from domestic buying, with the percentage of household assets in Indian equities rising from 2.2 per cent in 2013 to about 3.5 per cent. While the peak of nearer 5 per cent is still some way off, the trend is certainly moving in the right direction. We would expect to see further domestic buying as the cultural change persists.

This change has been facilitated by a set of cohesive steps. The first being the introduction of the Aadhaar unique identification scheme, with more than one billion Indians now registered on the nationwide database. In addition, to that, Prime Minister Modi’s ‘no-frills’ bank account scheme has seen nearly 300 million accounts opened in the past three years. Throw in the demonetisation move and it is clear to see the Indian population has greater access to financial services than ever before.

Shilan Shah is India economist and Mark Williams is chief Asia economist at Capital Economics

A year after the Indian government’s surprise announcement that the bulk of the country’s bank notes were being cancelled, it is clear that the negative impact on incomes and output was substantial – though temporary – while the hoped-for benefits failed to materialise.

The RBI estimates that 99 per cent of affected bank notes have since been deposited or exchanged for new currency.Those with assets to hide either hadn’t been storing their wealth in cash or found means to launder it so that it could be deposited.

The currency shortage immediately created severe economic hardship for much of the population, and caused growth to slow. GDP growth slowed from 7.5 per cent year on year in Q3 2016 to 6.1 per cent in Q1 2017. We are less convinced than many others that the further slowdown to 5.7 per cent in Q2 can be attributed to demonetisation.

There have been some positives. Demonetisation led to the opening of more than 20 million bank accounts, as the initial shortage of replacement banknotes forced some of those handing in old notes to open accounts for the funds to be deposited in. And the lack of cash in circulation led to a surge in adoption of cashless payment methods, such as card transactions, by retailer and consumers. This appears to have led to a lasting change in spending behaviour which may boost efficiency over the medium term.

More important though, by encouraging more payments to be channelled through the banking system, the demonetisation process enlarged the size of the “regular” economy. This should broaden the tax base – the government estimates that more than nine million new taxpayers have been registered as a result – and improve tax compliance more generally. Tax revenues in India are lower relative to GDP than in all other major emerging markets.

But these positives should not be exaggerated. Twenty million new bank accounts is not a huge number given India’s population. More than 60 million were opened in the 12 months before demonetisation as part of the government’s PMJDY financial inclusion scheme. The bigger problem that the PMJDY scheme has uncovered is not getting people to open accounts but getting them to continue using them: many lie dormant. If households and firms return to cash transactions, the tax gains won’t materialise, and there will be very little positive to set against the disruption and hardship that demonetisation caused.