1. Demonetisation: Is it enough?

Demonetisation: Is it enough?

It is hard to imagine if the attempted demonetisation move will actually lead to the desired result

Published: November 18, 2016 6:18 AM
atm In India, there have been two previous attempts at demonetisation. The first was when R1,000, R5,000, R10,000 notes were taken out of circulation in January 1946.

Demonetisation in basic economics is defined as an act leading to the stripping of a currency unit from being used as a legal tender or medium of exchange. The practice has been extensively used by central banks and governments to either change the circulation of a given national currency or replace an existing unit. In India, where PM Narendra Modi shocked the nation with his announcement to ban R500 and R1,000 currency notes (reminiscent of the Nixon Shock in 1971), the demonetisation attempt has largely been aimed at combating the creation and circulation of illegal wealth.

In India, there have been two previous attempts at demonetisation. The first was when R1,000, R5,000, R10,000 notes were taken out of circulation in January 1946. All three denominations were however, reintroduced for circulation in 1954. The second was in 1978, when Moraji Desai-led Janata Party coalition, used the High Denomination Bank Notes Act to declare these three denominations as illegal. IG Patel, the RBI governor in 1978, criticised Desai’s demonetisation attempt. However, this time around, Urjit Patel (current RBI Governor) has backed Modi’s move while acknowledging the “growing menace of fake Indian currency notes” that further exacerbate corruption levels.

While there are many scholars that argue in favour of keeping lower currency denominations in higher circulation as against currency notes with higher denominations, it would be interesting to see some of the administrative challenges involved in implementing the demonetisation attempt and assess, to what extent, the measure can actually help in combating corruption.

Recently, economist Ajit Ranade in an article, argued how “large denomination notes are highly likely to be used for illegal activities and not so much as a medium of ordinary transaction.” One reason for this is because, currency notes with high denominations (like 1,000, 10,000 etc.) are rarely used on a day-to-day basis and ultimately serve the best interests of money launderers, real estate players or other tax evaders.

In addition to studying the likely impact of demonetisation on illegal cash transactions or illegal wealth to curb black money, it would be worthwhile to note the impact of the decision on RBI’s own process and cost of printing new denominations. The share of R1,000 notes in the stock of currency circulation is as high as 39% and R500 notes account for 45% of the currency stock. Combined, the share of R500 and R1000 notes account for over 85% of all currency notes in current circulation.

The cost of printing different denominations of Indian currency notes is something that RBI will need to be wary of in the upcoming transitionary phase (as it moves from scrapping old currency denominations and replacing them with new ones). As R500 and R1,000 currency notes go out of money stock (for the time period), the demand for currency notes with smaller denominations (R10, R20, R50 and R100) will scale up severely. Noted by a recent study, “the cost of printing a R10 note is R0.96 or 9.6% of face value, while the cost of printing a R1,000 note is only 0.32% (or R3.17) of the face value”. Thus, RBI would need to incur some significant higher costs in stopping the issuance of R500 and R1000 notes, and replacing them with other denominations over time.

Additionally, for those with a history of paying taxes diligently, demonetisation is likely to be an administrative nightmare especially for banks which may find it extremely difficult to cope up with the pressure of handling long queues as people come to exchange older currency notes for newer ones. While this may seem to be a temporary problem for administering a currency reform change, it is hard to imagine if the attempted demonetisation move (in combating generation of illegal wealth) on its own, will actually lead to the desired result unless persistent, ancillary measures to curb corruption or illegal wealth are not followed.

On deconstructing the basic essence of corruption, in a simple yet powerful formula (as per Robert Klitgaard’s model), corruption (as a crime of calculation), equals monopoly plus discretion, minus accountability (i.e. C=M+D-A). And, wherever these conditions shall continue to exist (whether in the public sector or private sector), corruption, including the circulation of illegal wealth shall continue to exist. The institutional solution to corruption, going beyond demonetisation lies mostly, in promoting reform measures in demonopolisation across sectors; eliminating human discretion by ensuring the filing of e-returns for income tax, conducting automatic assessments and sending tax refunds to assessee bank accounts; and, ensuring financial accountability through effective income declaration methods.

India, as one of the most cash intensive economies with a cash-to-GDP ratio of 12%, which is almost four times higher to other emerging economies, like Brazil (3.93%), Mexico (5.3%), South Africa (3.73%) has still a largely unbanked base. For the widely spread rural India, a radical switch to electronic payment systems or plastic money (as a result of demonetisation) seems unrealistic and will require persistent efforts in ensuring parity for enabling disclosure of unaccounted wealth.

Having said that, the problem with fund mobilisation (using cash to fund polls) usually attached with political parties (in times of election season), where more and more cash is distributed as a medium of exchange is likely to be brought under check for the time. The Modi Shock may thus, have a significant impact on the UP elections which are due in the next couple of months and where the frequency and density of cash transactions is far more than other state in India (owing to its large unbanked, informal market base).

One of the other likely advantages of the demonetisation step can be in respect to increasing the level of bank deposits (with people in thousands coming to declare black money held with them in form of currency notes of R500 and R1,000). The process may allow banks to significantly boost their household deposits, allowing them a higher capital base—useful in further increasing lending and credit.

In any case, the demonetisation currency reform move by the Modi government can be summed up as a welcome bold move, one that will require consistent efforts on part of both the government and the central bank to ensure its efficacy in combating the rise of black money and corruption levels.

Deepanshu Mohan

The author is assistant professor of economics, assistant dean (academic affairs), executive director, Centre on International Economic Studies, Jindal School of International Affairs.

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