In a massive move, Prime Minister Narendra Modi announced the demonetising of Rs 500 and Rs 1000 currency notes. According to Investopedia, demonetization is the act of stripping a currency unit of its status as legal tender. The idea behind the effort, as Modi suggested in a long preamble before his announcement, is to attack corruption and make black money harder to use.
This isn’t the first time India has demonitised its currency. In 1946, the Reserve Bank of India actually banned Rs 1,000 and Rs 10,000 notes, primarily to deal with unaccounted money. These were then reintroduced with a Rs 5,000 note in 1954, before they were once again demonitised in 1978.
The aim of taking the Rs 500 and Rs 1,000 notes out of circulation is to reduce the amount of illicit money in the economy. Simply put, many economists believe that high-value notes make it much easier for black money to move around the country, without necessarily being beneficial for law-abiding citizens or the poor. Next government also wanted to eliminate fake currency and dodgy funds which have been used by terror groups to fund terrorism in India. The move is estimated to scoop out more than 5 lakh crore rupees black money from the economy.
However the honest taxpayers need not to worry. Even if you have Rs 10 lakhs as cash with you and you can prove its legitimacy, you don’t need to worry. The surprise move by government is a disaster for people who have accumulated lakhs and crore of unaccounted cash under their pillows and mattresses. The winter is coming and these worthless pieces of paper can provide the corrupt some ephemeral warmth.
The timing of this announcement seems obvious, in hindsight. With the massive rollout of the Pradhan Mantri Jan-Dhan Yojana (PMJDY) in India, citizens’ access to bank accounts is nearly complete. A demonetization move would have been impossible if low-income households were unbanked. PMJDY has provided them with free bank accounts, which will also be used to transfer government payments. The need for honest people to stash cash in mattresses, therefore, has diminished. This move by the PM has also followed the income disclosure scheme where people were given a window of opportunity to declare their wealth amassed through various means. It was an appropriate time, therefore, to make credible the threat of a crackdown on black money and corruption within India.
Of course, actually implementing this is something of a mammoth task. Modi explained how the country is planning to carry out this massive operation over the next few months, as millions of Indians will attempt to exchange their old notes. It will stretch the capabilities of the financial system, which already does not extend across the country, and the interim period will also see many attempts by those holding on to black money to turn their cash into legal tender. The effort also depends heavily on Indian authorities actually delivering on the promise to make it easy for people to turn their old currency into smaller denominations. After this, the government plans to reintroduce a new Rs 500-denomination note, with limited circulation.
The biggest sufferers would be unorganized and informal sector as they predominantly deal with cash. Other loser would be mid-cap and small- cap companies which collect and make payments in cash. This pain will continue till this stock of cash is replenished by the banking system, which can be a quarter or two.
On inflation, the price level is expected to be lowered due to moderation from the demand side, according to CARE Ratings research paper. Some economists say that lower money supply would lead to deflationary pressure with too little money chasing too many goods. However, on the contrary, some economists believe that the move might work the other way round and help curb inflation with lower money supply as unaccounted money would be taken out of the system. In the long run, this is a significant positive shock to the Indian economy and society. If substantially implemented, this will send a strong signal about India’s anti-corruption drive and is very likely to improve the country’s reformist stance.
In spite of the initial hiccups and disruptions in the system, eventually this change will be assimilated in the system and is to eventually prove positive for the economy in the long run. Whether this would eventually boost economic activity that is remains to be seen. But, orders of magnitude are very difficult to establish and hence, any claim of such improvement in formal economic activity with consequent beneficial tax impacts and other social economic multipliers must be deemed wholly speculative at this stage. This move by the government along with the implementation of the GST will eventually make the system more accountable and efficient.
This article was written by Varnita Deep (PGDM, Batch 22, XIME-B