Monday, November 28, 2016

Demonetisation Guesswork

Unknown Unknowns

This is the largest scale pre-meditated currency manoeuvre in history. 

Any 'experts' making estimates of its impact on the economy are throwing darts with blindfolds on. 

Modern economies are extremely complex mechanisms, and throwing a spanner into their heart is not going to yield predictable results.I will not spend too much time on economic theory as I understand it; and the idea is not to toss out another random number on the impact on GDP, but to illustrate the way in which the ripples can work.

A central identity of a monetary economy is MV=PT, where
- M is the money in circulation; 
- V is the velocity of money, the speed with which it moves from hand to hand; 
- P is the price level, and 
- T the number of transactions.

If you take 86% of M out of the identity (leaving 14%, or 1/7), the right hand side, PT, can only remain the same if V compensates, which means it has to go up 7 fold. This seems very unlikely...looking at the behaviour around me, there has been, if anything, a tendency to hoard cash, that is , to actually REDUCE the velocity of money, by postponing purchases. (This will gradually fade; it will also partly be compensated by people migrating a higher percentage of their expenditures to non-cash. But this is not possible for 300++ million people without IDs, smartphones, or debit cards).

If then, PT has to go down, odds are we will see both going down, prices, and transactions. Both will negatively impact economic activity, of which GDP is the primary measure. How much? This is impossible to predict.

At any point in time, many businesses - large and small, industrial, agricultural or services  - are marginal, with cash flow on the edge. Many will fail, and this is part of the cycle of "creative destruction" articulated by economist Joseph Schumpeter. But a huge disruption like this will abruptly push many more over the edge. They will not return in a hurry, and their consumption  will drop, with a second feedback loop into the economy. This feedback could keep echoing into a vicious circle.

The government will try to address this by increasing spending. However, tax revenues will have gone down with reduced  economic activity, so this will lead to greater deficit financing. Will this feed through to inflation coming back? Impossible to I suggest above, the feedback loops are complex and unpredictable.
Expect volatility, especially in prices:
- of goods and services (down, then up?)
- of money, as in interest rate (sharply down, gradual correction?)
- of foreign exchange (down?)

These will feed through to volatility in asset prices - of real estate, stocks and gold.
The rational thing to do would be to prune asset holdings where the corrections are not already too sharp, and keep money aside, to buy at future dips.

Most likely to be hit:
- Domestic consumption, especially rural.
- Real estate

Likely beneficiaries:
- IT, via rupee weakness
- Infrastructure, as the government tries to stimulate the economy.

- Banks, which will struggle with crimped credit demand. They will see a one-off kicker from low interest rates, which leads to a jump in bond prices. However, as we have already seen, the Central Bank will go into policy overdrive, as it struggles to keep pace with the unpredictability of economic developments - witness the decision to impound 3.25 lakh crores of sudden bank deposits.


  1. Wow Mohit. Loved the way you explain the MV=PT equation. The economic impact of demonetization is well explained and while that is something the country is grappling with - what disturbs me is the manner in which the decision was taken. Top of that is the execution failure which is discomforting and will certainly impact consumer sentiment and consumption patterns.

  2. A society as complex as India, with wide-spread failure of governance requires decisions to be made carefully. Yes, the manner of decision-making is troublesome. This need to invent silver bullets for deep-set problems is part of our short-cut mentality to all problems.