If one changes the medium of exchange, the exchange comes to a grinding halt! This is what we’ve seen over the last few days, after the central government demonetised the use of old R500 and R1000 currency notes, that took everybody by surprise. But this is only a temporary phenomenon.
Demonetisation may have created a temporary chaos and discomfort among the general public but it promises huge benefits. Of course, certain well-known benefits of introducing new, more secure, currency notes are: removal of black money (unaccounted income stored in currency notes) and stamping out of fake currency. Further, some experts believe that by reducing “black money” from the economy, a higher share of total transactions will come under the tax net, and thereby bolster tax revenue in medium term. Others believe that the demonetisation will increase the pace of financial inclusion and adoption of net-banking. These are all the known benefits associated with the demonetisation.
However, there are other lesser-known but significantly powerful benefits associated with it. One such benefit is of greater formalisation of the economy.
The Indian society is known to be an informal society. One of the interpretations of this informality is that people often engage in transactions on the basis of trust alone. That is, people lend and borrow money, buy and sell commodities on credit, enter into business deals on the basis of trust, without entering a formal contract. Word of mouth is good enough to strike a deal! The demonetisation has put this “trust factor” to test, which can be illustrated with the help of three contexts.
First, the trust between the parties who lend and borrow money in currency notes, which is a common practice among people having unaccounted income, has been shaken. This lending and borrowing invariably happens in higher denomination currency notes when the amounts involved are large. The demonetisation is likely to create tension in commercial, and even social, relations as people who borrowed in higher denomination currency would want to return the borrowed money in the same currency notes. But because the old currency notes are no longer a valid legal tender, such borrowing/lending transactions have the high risk of remaining unsettled, thereby resulting in souring of relations.
Second, the routine business relationships that prevail between local retail vendors and residents in a close neighbourhood community has also been put to test. The demonetisation saw the erosion of trust when, for instance, a local shopkeeper refused to give merchandise on credit or offered to honour the currency notes at “reduced” value. Even if this phenomenon is temporary in nature, it has questioned the long-standing trust that once prevailed between buyers and sellers in a neighbourhood community.
Third, a cordiality enjoyed among friends and relatives has also come under stress. For example, people having cash-at-hand disproportionate to their income, are requesting their friends and relatives to help them convert their old denomination currency into the new denomination. Certainly not all of their friends and relatives will happily oblige!
The sheer scale of the scheme is likely to have far reaching ramifications. The demonetisation scheme would result not only in people reviewing their need for hoarding cash—both for transaction and precautionary purposes—but also in quicker adoption of the digital technology that enables cash-less transactions. More importantly, the trust-shaking experience of the scheme will encourage people to revisit their existing relationships, business or otherwise, and the manner in which they mediate financial transactions. This will likely lead to greater formalisation of relationships particularly among the business community.
A formalisation of the economy is both a good news and a bad news: good news because this will lead to a professional approach among people in financial matters; and bad news because this will mean a demise of the advantage of ease that go with an informal approach!
The author is a development economist formerly with Bill and Melinda Gates Foundation and the World Bank