Explained: The unintended disastrous consequences of demonetisation

falling-indian-economyJ.Vishnu Shankar:

“Jagame maaya” -said one wise poet. It simply means that what is seen is not what it actually is. On the face of it, the intended results of demonetisation are 1) rooting out black money which has accumulated in the system 2) making all counterfeit notes invalid 3) dealing a body blow to terrorist funding which has its roots in unaccounted money and 4) moving towards a cashless economy.

All noble intentions, no doubt. The underlying assumption is that this sudden action of demonetising high value notes will put fear into people for whom black money is a way of life, and as a consequence India will move faster to become a white economy there by bringing more transactions in to the tax radar and help greater tax collections. And those higher tax collections can be put to good use by governments for uplifting people from poverty. Nothing to fault, you may say. It all looks so good on paper. But to know how it actually works in a complex economy like India, you may have to take a look from a completely different premise.

And the premise of this article is simple. Economies improve when consumer spending improves. Consumer spending improves when they have more money in hand. And consumers can have more money in hand in only two ways. 1) When more jobs are created in the economy so that more people earn , and some earn more, and most importantly 2) when asset prices increase at a faster rate than inflation so that asset holders get windfall gains.

This article will focus on the asset-prices angle but I will briefly touch the job creation part first. We already know that even before 8th Nov, India was losing about 550 jobs per day. ( READ HERE). It is common knowledge that this number will only increase post demonetisation. Several cash dependent sectors including agriculture and construction will be badly hit for the next one year if not more. The scene in organised sector too is not rosy. IT jobs have all but vanished. Start up job creation has almost ended. And non-IT corporate sector too is laying off. L&T recently laid off 14,000 people.

Now coming to the asst price angle, here is why I am pessimistic on Indian economy at least for the next 3-5 years. I will try to present it as effectively as I can.

  • Indians have always bought gold and real estate ( and also shares) as an investment so that they can be sold at a higher price when needed to fund important personal events like children’s education and marriage. It is not at all uncommon for families to buy a small plot / site apart from their permanent house so that they can sell it for daughter’s marriage.
  • We have also seen that after selling their real estate, and apart from funding a personal event, people also do some shopping like buying automobiles, luxury goods, go on domestic / foreign vacations etc. In fact many farmers having lands 20-50 kms from several cities and towns have become rich overnight after selling their lands to builders and have bought all kinds of goods, even Mercs and BMWs.
  • People also rent out the additional apartment, earn some extra income and spend it. Probably they bought the latest smart phone, LED TV, changed the furniture, painted the home and also paid a little more to the maid, driver etc there by increasing their consumption index several times.
  • Let us understand that the very reason gold and real estate is bought is because there is an underlying unshakable faith that it can always be sold at a higher price. What happens when this faith is shaken ? Why would anybody buy real estate / gold if it is about to depreciate in future ?

The government’s argument is that by removing the black money component from gold and real estate purchases, the prices will come down to affordable levels and hence more people will buy. The biggest fallacy in this argument is that while this works for consumer durables which are pure consumption products, it does not work for products like gold / real estate which have an investment story built into them. It is all very fine to think that Apple iPhone 7 can sell more if it drops its prices but nobody will buy a home whose price will fall in future. Interest rate reduction too will not improve real estate market if the prices were to fall in future. For example between 2004-2008, interest rates went up steadily. Home sales should have reduced in that period but they went up multifold. Similarly, gold touched around 30,000 in late 2012 and fell to almost 22, 000 in the next 2 years. Gold sales should have gone up but they in reality went down drastically.

Demonetisation has dealt a body blow to the unshakable faith Indians had in the logic of buying real estate and gold for a rainy day. Gold may still escape the axe as its price is dependent on international prices and the value of the rupee. But real estate being a domestic industry is more in the grip of public sentiment. One might argue that things will be back to normalcy when real estate industry embraces white money in totality. But realistically speaking, is it that simple, even if immensely desirable ??

Impact of negative real estate returns will show up in many ways. It will badly hit

  • 20 other sectors like steel, cement, tiles, paints and other building materials
  • Crores of construction workers, builders and agents who are dependent on real estate fortunes
  • Crores of middle class investors who bought small sites and flats, mostly funded by loans and paying EMIs.
  • Banks and NBFCs, some part of whose retails loans may turn NPAs
  • Purchases of autos, luxury goods, domestic travel and many other small impulsive purchases
  • A very big informal section of Indians who some how make a living by doing odd jobs
  • And also a reasonable portion of stock market returns

Coming back to my basic premise, when job creation scenario is bleak and getting bleaker, government should have thought twice, thrice and multiple times before doing anything that will result in asset price deflation. Economists advising the centre, if the centre was talking to any of them in the first place, should have warned about the impending catastrophe. That the government still went ahead suggests that this was never given any due consideration.

The Indian consumption story is about to come to a screeching halt with the double whammy of job losses and asset price deflation. The economy is sure to tumble, particularly when private corporate investment too has not been taking place. And the ill-effects of demonetisation are unlikely to go away in a hurry. They are here to stay for 3-5 years at least.

My fellow Indians, save your backside. It is under serious attack !!

 

 

 

 

 

 

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2 thoughts on “Explained: The unintended disastrous consequences of demonetisation

  1. This is a wrong prediction the author himself proved :

    //We have also seen that after selling their real estate, and apart from funding a personal event, people also do some shopping like buying automobiles, luxury goods, go on domestic / foreign vacations etc. In fact many farmers having lands 20-50 kms from several cities and towns have become rich overnight after selling their lands to builders and have bought all kinds of goods, even Mercs and BMWs.​//

    ​This means buying from the surplus cash after selling real estate at an inflated rates is good?
    This is the crux of the issue. A notional value is converted by the emotions into an inflated price at which only the blackmoney holders buy.

    I strongly feel that demonetization brings in so much discipline among all sections of society and some people continue to act of hubs of corruption and for them no ban can alter them.​​

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    • Raju garu, everything in the world has only a notional value. Why should SBI shares be selling today at 259/- and not 159/-. Why should rice sell at Rs 50/- and not Rs 10/-. Why should a bank officer earn 50K per month and not 5K ?Who fixed the price ?? It is the market. Real estate prices too are fixed by the market. Prices go up if there are buyers. And do only black money holders buy real estate? Did you and me buy our homes out of black market money ?? Not at all.

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