Demonetisation: What it means As we all know, on Tuesday, Nov 8, 2016, in a historic televised address to the nation, India s Prime Minister Narendra Modi announced that Indian currency notes of denominations INR 500 ($7.5) and INR 1000 ( $15) would cease to be legal tender with effect from midnight of 8th Nov 2016. These existing large value notes can be exchanged at banks till 31 Dec 2016. Accordingly, the RBI has started to issue new Rs 500/2000 notes starting from 10th November. At this point of time, there is plenty of chaos. Small denomination (Rs 100) notes are not easily available and card swiping machines in some retail outlets are unable to take the load during peak hours. But there is a mood of optimism among the country s intellectuals and to some extent even among the common people that the move will be beneficial for the country in the long run. While the move is specific to India, reduction of cash in the economy and greater use of electronic payments have larger implications even for developed countries, as we will see in this article.
Background Withdrawal of existing currency notes and replacing them with new ones is not a new phenomenon for central banks. For example, this is a practice commonly followed by the Bank of England to improve security, prevent counterfeiting and use better materials to prolong the life of the notes. Bank of England issued a new polymer 5 note on September 13, 2016. People can continue to spend paper 5 notes as usual until May 5, 2017. After this they will cease to be legal tender. BOE has also announced that a new polymer 10 note will be issued in the summer of 2017 and a new polymer 20 note by 2020. In India too, RBI has a standard practice of periodically upgrading security features of banknotes to stay ahead of counterfeiters. The last such up-gradation was done in 2005 with a new series of banknotes. Certain new features such as bleed lines and exploding numbers (Some of these features are for the benefit of the visually impaired and others are for improved security.) were introduced during 2015-16. In the last financial year, 632,926 pieces of counterfeit notes
were detected in the banking system, of which 95% were detected by commercial banks. This is not the first time that demonetization is happening in India. The country s first demonetization took place in January 1946 and the second in January 1978. On both occasions, the elimination of black money was the main reason for demonetization. In 1946, before independence, notes of the value of Rs. 500, Rs. 1,000 and Rs. 10,000 were withdrawn. It was reported that out of currency worth Rs 1,220 crores then in circulation in India, Rs 200-300 crores of notes of Rs. 500 and higher denominations had gone underground to evade taxes. Eight years later (1954), the Reserve Bank of India re-introduced the high denomination notes (Rs. 1,000, Rs. 5,000 and Rs. 10,000). And during the Janata Party government ( the first non-congress government at the centre in post-independence India) led by Morarji Desai, the people were surprised by a late night ordinance issued on January 16, 1978, which pronounced that notes of the denomination of Rs. 1,000, Rs. 5,000 and Rs. 10,000 had ceased to be legal tender. Why the current demonetization? The current demonetization scheme has been introduced to contain the rising incidence of fake notes and black money in the economy, for increasing security and countering terrorism. This is a strong argument that is well accepted across the world. In his book, The Curse of Cash, Kenneth Rogoff, the well-known American economist argues that cash plays a central role in drug trafficking, racketeering, extortion, corruption of public officials and human trafficking. And for all these illegal activities, large denomination notes are more commonly used than small denomination ones. Rogoff argues that even illegal immigration can be curbed if under the table, cash wages to foreign workers go away. There is no need to build a fence on the US Mexican border, as Mr. Donald Trump wants to do! It is clear that Prime Minister Modi means business. The decision to withdraw the higher value currency notes comes as a sequel to the income declaration scheme
recently completed and an earlier scheme aimed at bringing back unaccounted money kept outside the country. The earlier disclosure schemes were more in the nature of amnesty. But the current scheme is different. Anyone who has large amounts of cash and cannot account for it will have to pay stiff penalties. More specifically, banks will have to report to tax authorities anybody depositing over Rs 250,000 ($3,765). Such people may have to pay a penalty of 200% of the tax owed. The Indian economy had Rs 17.3trn (US$ 260bn) of currency in circulation as of Sep'16 with INR 500 and 1000 notes comprising 86% of the value of currency in circulation, or 10.4% of GDP. Currency in circulation has increased by 15% in the last one year and 42% over the last three years, well ahead of nominal GDP growth. At the same time, the growth in Rs 500 and 1000 notes has been faster than that of the smaller denomination notes. The SIT (Special Investigation Team) on black money, set up by the government had earlier released a report highlighting the need to restrict cash transactions and holdings to counter unaccounted wealth. The World Bank has estimated the size of India's shadow economy at 23.2% of GDP. An estimated 78% of transactions in India were in cash in 2015 (according to the Boston Consulting Group). In developed countries, cash contributes to just 20-25% of overall consumer payments. (But even in the US, some $ 1.34 trillion worth of currency was held outside banks at the end of 2015, almost 80% of it in the form of high value $ 100 bills.) The implications The scope for exchanging old notes for new at bank counters is limited, with an initial cap of INR 4000 per person and later reduced to Rs 2000. Anything above that will be credited to the bank account. The access to cash from ATMs will also be severely restricted. So the supply of cash in the economy will be temporarily reduced. Already, there are reports that banks and ATM machines are unable to handle the public demand for smaller denomination Rs 100 notes. As a result,
there will certainly be some dislocation and inconvenience for individuals and businesses. A good friend wrote to me on Wednesday, Nov 9: This morning I was at a petrol bunk; a labourer wanted me to help get him change for Rs 500. There was no way he could get that change and his 500 rupee note was of no value especially with banks being closed. Unless he finds a creative way, he will go hungry. Economic growth will also be affected in the short-term. Households will probably put off purchases such as white goods. Coffee and cardamom growers of Kerala have already started to complain that the new cash withdrawal limit is too small for them to be able to pay wages to laborers during the harvest season. Truck drivers have been hit badly. On an average, for a long trip, they carry Rs 16,000 for food, vehicle maintenance and fuel. Because of the shortage of cash, only half of the 450,000 trucks in Tamil Nadu are plying. Jewelers, doctors and others in professions where cash still rules will also be hard hit. Even e-commerce sites like Amazon will be affected. Over two-thirds of their sales in India are settled by the buyers in cash on delivery of goods. The real estate sector which has depended heavily on cash payments is likely to be affected. There is a strong speculation that house prices will fall. But this could be good for people aspiring to own their first home. The Tamil film industry (as indeed would be the case with the Hindi film industry) is also feeling the pinch but hopes it will successfully make the transition to an era of electronic payments. The poor people who keep their savings as cash at home and who still do not have a bank account or proper proof of identity will be the most disadvantaged. But one disadvantaged group that will not get much sympathy from the general public consists of politicians, who will no longer be able to hoard cash for election-time handouts. Politicians in UP which faces elections shortly are a worried lot.
At the same time, the banking system deposits will increase substantially, leading to a significant improvement in banking system liquidity. On Nov 10, Rs 22,150 crores were deposited in SBI while only Rs 723 crores were exchanged. In just one day, savings deposits increased by Rs 11,000 crores at SBI whereas the monthly increase in normal times is about Rs 8,000 crores. One bank CEO has mentioned that there is every possibility that deposit interest rates may come down by up to 1.25% over the next 6 months. There might be a positive impact on the government s fiscal deficit as well. Some of the notes will not be exchanged and will go out of circulation as the holders may want to keep their identity concealed. According to Business Line, if we assume that about 10% of the Rs 500 and Rs 1000 notes, or close to Rs. 1.5-2 lakh crore of notes don t come back into circulation, the RBI would make a handsome profit and that profit Is likely to be transferred to the Government. The fiscal deficit for 2016-17 is projected at about Rs. 5.33 lakh crore or 3.5% of GDP. With the bonanza of Rs. 2 lakh crore, the fiscal deficit may well come down to 1.5-2%. Finance Minister Arun Jaitley would have achieved his fiscal deficit target in style without a sweat! This in turn would make lower interest rates more feasible. (Lower deficit means less need for the government to borrow. Heavy government borrowing leads to an increase in interest rates, a phenomenon described by economists as the Crowding Out effect.) Reducing the scope for hoarding black money means in the long run, the tax base will expand. In a country of more than 1300 million people, only 30 million file income tax returns and of them only half pay taxes. India s tax to GDP ratio is lower compared to other emerging economies. The government s clampdown on black money will hopefully expand the tax base and reduce the tax rates in the long run. There is good news for Fintech. Because of the limited availability of cash, spending habits of people have already started to change. Digital wallets such as OlaMoney, FreeCharge, Fino Paytech, Paytm, Oxigen and ItzCash are seeing a massive spike in terms of downloads and recharges. Paytm, the largest digital
wallet player in the country, expects to get 500 million Indians on board by 2018, well ahead of the earlier target year of 2020. Snapdeal s wallet Freecharge recorded over 12 times jump in deposits within hours of discontinuation of old notes. ItzCash, another major player, saw 30-40% growth in the volumes traded since Tuesday night. MobiKwik registered 40% growth in app downloads and has revised its growth projections. OlaMoney has also seen a manifold increase in transactions. Will the move succeed? While the scheme is bold and visionary and a potential game changer, one point to keep in mind is that high value notes will not go out of circulation. They will only be replaced. And as the Economist has rightly mentioned the new 2,000- rupee note cannot really be used by the common man for day to day transactions. It is more likely to be used for mattress-stuffing, smuggling or gambling. Getting change for even a 500-rupee note is already close to impossible today. In the past week, whenever my wife or I have gone to the bank, it was more keen on handing over Rs 2000 notes. There is a huge shortage of Rs 100 notes. Is the scheme completely foolproof? There is already evidence that Indians have once again started to prove how ingenious they can be when facing adversity. At the most basic level, some are looking to mobilize friends, cousins, domestic staff, and even senior citizens who are prepared to go to the banks and legally exchange the cash in small enough chunks to avoid scrutiny. Others are paying agents for buying expensive air conditioned first-class train tickets with old notes (Railways have been told to accept the old notes for some time.) and then cancelling them later to get reimbursed in new notes. There are more ingenious schemes as well. One such scheme that seems to be thriving is jewelers accepting the old Rs 500 and Rs 1000 notes at a steep discount and selling gold with backdated invoices. The jewelers are betting that they will then be able to deposit the money in banks without any questions being asked.
Another cunning scheme involves people with excess cash (typically based in Mumbai) passing it on to loss making small enterprises (typically based in Calcutta). These entities then deposit the money in their bank account and they have valid documents to account for the cash. The next step is for these entities to give a loan to the original lender who in turn will pay back the loan by cheque at a later date. And finally, the original borrower will withdraw this money from the account and pay it back to the original lender, the person who had the surplus Rs 500 and Rs 1000 notes. The government has mentioned it is carefully monitoring all suspicious transactions but there is a limit to what it can do! Another important point to note is that a significant part of the black money is not held as cash but as assets of fictitious entities in the formal financial system. So a war on black money cannot be limited to demonetization. Real estate, a sector which has fuelled the growth of black money, must be brought within the ambit of the Goods and Services Tax ( the new value added tax system that is being rolled out in India) so that property developers will start claiming tax credits and there will be an audit trail. Last but not the least, the current scheme will only attack the accumulated stock of black money. Preventing future generation of back money will call for a more business friendly environment and lower taxes that will reduce the incentive for holding black money. For example, states who administer many land related transactions must lower the currently high levels of stamp duty to encourage reporting of transactions. Concluding notes For all the hardships, the common man is facing, due to the demonetization scheme, the government must give something in return. One suggestion from the Times of India is to use the additional revenues generated to transfer money directly to people using Aadhar (Social Security Number) and Jandhan ( A scheme that enabled many poor people to open bank accounts). Simultaneously, the government must phase out price subsidies which have not only led to market distortions but also failed in their objective of reaching the benefits to the
targeted beneficiaries. Let us also hope, as a friend has pointed out, that those with too many Rs 500 and Rs 1000 notes, with few other alternatives left, will give at least a few of them away to poor people who might be able to exchange them for new notes. After all, in all religions, charity is considered to be an important step towards salvation. And finally, while on the subject of cash in the economy, there is another important dimension that we should also consider. In many developed countries, interest rates are close to zero or even negative. Central banks cannot reduce interest rates any further at a time when GDP growth is still weak. It is in this context that Rogoff, mentioned earlier, argues that elimination of cash will enable central banks to reduce interest rates to any negative value that they want. This may be a powerful tool for central banks in an era of low interest rates. Currently, there is a limit on how negative interest rates can get, because there is an alternative, called cash that at least guarantees zero interest rate if not higher. Come to think of it. Currency notes are effectively zero interest bonds. Take away these bonds. And this limit goes away. Central banks would have bullets to fire even in the low interest rate environment that we are seeing today. Rogoff argues that an uncapped negative interest rate policy would have got us out of the global financial crisis faster. The so called liquidity trap that we learnt in Macroeconomics 101 would not exist.