Narendra Modi government's controversial decision to ban high denomination currency notes (HDNs) has been a gold mine for economic researchers. From its impact on GDP growth to how the electorals reacted to it, economists of all schools of thought have dissected the issue. But what have left many confused is the wide gap in the relative figures between the GDP data put out by the government during the demonetisation period and the negative impact on growth pointed out by many economists.
A new study titled Cash and the economy: Evidence from India's demonetization co-authored by India-born Harvard professor Gita Gopinath, who is set to take charge as the chief economist at the International Monetary Fund (IMF) next month, suggests why the decline in output was not reflected in the national GDP data.
According to the paper published by US-based National Bureau of Economic Research, the government's note ban decision shaved off economic growth by at least 2 percentage points for the October-December quarter of 2016 in which the demonetisation move was effected.
The study uses a “new household survey of employment” and “satellite data on human-generated nightlight activity” and a number of other datasets to measure the effects of demonetisation at the district level.
The study estimates that the note-ban also led to a decline in “nightlights-based economic activity and of employment of 3 percentage points or more in November and December of 2016 relative to the counterfactual path”. This, the study notes, led to “a decline in the quarterly growth rate of 2 percentage points or more”.
However, what made the study infer the impact of demonetisation on the real economy is the methodology used. The study has used a cross-sectional approach. The currency ban came at a time when the Indian economy was subjected to many other external shocks and policies such as the election of Donald Trump which occurred on the same day as the demonetisation announcement, a rise in the global price of crude oil of 60 per cent from January to October 2016, a better monsoon in India than the previous year, increased uncertainty related to capital flows into foreign currency non-repatriable accounts and accompanying exchange rate volatility in November 2016. The absence of a clear break in the data and the existence of other shocks made it difficult to assess the impact of demonetisation on real economy using time-series trends, which prompted the researchers to opt for a cross-sectional approach.
The advantage of cross-sectional approach pointed out by the economists include: (a) it holds constant other policies or shocks which affected the whole economy around the period of demonetisation, and (b) instead of a single time-series with a possible break in November 2016, a larger sample size spread across the country (geographic variation of demonetisation) gives a more accurate picture of the effect of demonetisation.
While explaining the volatility of the national data, the study has also touched upon a highly disputable topic among the economists in the country, which is, the informal sector. The paper points out that the national data do not capture the informal sector very well, an issue which was already flagged by many economists.
“While the level of official GDP includes an estimate of informal sector activity derived from a quinquennial household survey, quarterly changes in GDP do not reflect any direct measurement of informal sector activity,” the study says.
What makes the informal sector crucial in understanding the real economic activity is the fact that the sector is estimated to account for 81 per cent of total employment (according to International Labour Organization figures of 2018) and 44 per cent of total output (Central Statistics Office figures of 2018) in the country, and it is especially cash-intensive.
The study concludes that “our results also point to the likelihood of an absolute decline in economic activity at the end of 2016 since it had directly incorporated informal sector activity”, which the official statistics failed to capture.
The study also points out, “There may be longer term advantages from demonetization that arise from improvements in tax collections and in a shift to savings in financial instruments and non-cash payment mechanisms. Evaluating these long-term consequences requires waiting for more data and an empirical strategy suited to the study of longer term effects.”
In addition to Gopinath, the paper’s co-authors include economist Prachi Mishra, former head of RBI’s strategic research unit, and Abhinav Narayanan, a current research economist at the RBI. Harvard professor Gabriel Chodorow-Reich is the lead author.
The study comes at a time when the statisticians and economists in the country are divided over the methodology of calculation of GDP figures—the back-series GDP data being the latest in the line—and other important data on employment. The report is most likely to rake up the debate at least among academia, if not the political row over the most controversial financial decision in independent India's history.