This scenario hinges on the crucial assumption that people holding a good chunk of the demonetised 500- and 1000-rupee notes will not be able to exchange them for new ones, for fear of questions regarding the source of the funds and the downstream risk of severe penalties. Estimates vary about how much of the high-value notes will disappear for good, and range all the way from 10 per cent to 50 per cent of the money stock. If we assume a conservative figure of 20 per cent, that wipes out Rs 3 trillion (or lakh crore) of cash—equal to about 2 per cent of GDP. It is safe to assume that almost all of that would have been cash in the hands of the relatively wealthy. This is expropriation on a mass scale.
This is not without cost, because money is fuel for the economy, and the disappearance of something approaching a fifth of the money-base must affect a whole range of economic activities. Construction activity might come down, given the setback to the real estate market; and consumer goods demand could be hit because unearned incomes (like bribes) are often splurged on gadgets, luxuries and holidays--remember that money constantly moves from being black to white and back to black, depending on the nature of each transaction. Many small businesses that mostly operate in the cash economy will be hit.
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The expected drop in real estate values could have a knock-on impact on consumer sentiment because of the loss of the wealth effect; if your house is worth less now than it was last week, you will feel less well-off, and this would usually prompt you to spend more carefully than before. Bear in mind that a house or apartment is usually the biggest asset owned by a household. The effects of all this might show up in unimpressive corporate results in the affected sectors, and in somewhat lower GDP growth.
The flip side, though, is that the Reserve Bank will be free from liabilities to the extent of the cash that has disappeared following demonetisation. It could use the resulting cushion in its balance sheet to transfer money to the Union Budget—giving the government the bonanza that economists have been talking about these last few days. How exactly such a transfer can take place from RBI to the government is unclear. But if the government spends the bonanza on schemes for the poor, the picture becomes simple: illegitimate cash has been taken from the rich and legitimate cash given to the poor. Lenin would have approved. Our own communists don’t seem to have realised this, or they would not have criticised the demonetisation.
Importantly, this bonanza is one-time, and will not be repeated. So whatever spending commitments are taken on should also be one-off — like a cash gift to families. The alternative is to spend on capital items, like infrastructure projects (think of the railway freight corridors, or expressways), which would counter-act the expected slowdown in construction. It could finance badly needed weapons for the defence forces. And it could even be used to simply write down government debt—which various committees have said is too high in relation to GDP. Perhaps the one thing to bear in mind is that the money should be spent well; one-time bonanzas should not be wasted.