Demonetisation: Paper currency can flourish even without government backing

By: and |
Updated: December 2, 2016 1:04:00 AM

India’s most recent demonetisation has arguably been more disruptive than the ones carried out in 1946 and 1978 respectively.

Banks and financial institutions have been unable to cope in the backdrop of inadequate supply of new legal tender, aggravated by the wait to recalibrate ATMs to handle new notes. (Reuters)Banks and financial institutions have been unable to cope in the backdrop of inadequate supply of new legal tender, aggravated by the wait to recalibrate ATMs to handle new notes. (Reuters)

What gives the rupee note its worth? One reason it is worthy is because the government backs it. Rupee bills are “fiat” money—decreed by the government as legal tender for transactions that fulfill one of the key functions of money, i.e., its role as a medium of exchange. Another and perhaps more reflective reason is trust. Students of macroeconomics will quickly recall evidence of gold, cigarettes, shells, etc, being used as medium of exchange because people were willing to accept these as such. If everybody is willing to do so, it implies the existence of what economists call ‘network effects’. A moment’s pause will reveal that such network effects are pervasive in the digital economy. What makes Facebook or WhatsApp popular and therefore valuable is the willingness of people to use it as a medium or platform to transact—the more people use it the more valuable it becomes.

In the Ely Lecture delivered in 2004 by the then Governor of the Bank of England, Mervyn King recalled an interesting anecdote concerning the Iraqi dinar. After the 1991 Gulf War, Iraq was divided in two: the south ruled by Saddam Hussein, the north governed by the local Kurds. Because of sanctions against Iraq, new currency notes could not be imported to add to the existing stock of Swiss-printed dinars. As a result, Hussein decided to print currency in abandon to finance government expenditure and simultaneously demonetised the existing currency, giving citizens three weeks to exchange the Swiss-printed dinar notes. Those who lived in northern Iraq could not exchange their notes, and the old notes continued to circulate. These Swiss dinars were also honoured in transactions in northern Iraq. When the two regions unified under the US administration that issued new dinars to replace the old, it came to no one’s surprise that that one Swiss dinar was worth 150 Saddam dinars at the par value of exchange. Undoubtedly these were unique circumstances, but a cautious lesson can be drawn: Paper currency can flourish even without government backing if there is trust.

India’s most recent demonetisation has arguably been more disruptive than the ones carried out in 1946 and 1978 respectively. In 1978, currency in circulation comprised 9.45 % of the GDP, while the demonetised notes (1,000, 5,000 and 10,000) made up less than 2% of the cash in circulation. The corresponding numbers today are 12.5 % and 86% respectively. It is perhaps fair to conclude that the lowest currency note to be demonetised today, i.e., R500 is quite pervasive in even transactions of the relatively less well-off. For example, if the floor for demonetisation was set at the same value as in 1978, i.e, R1,000, it would be upwards of R13,000 today. A recent study by the Payment Council of India and Pricewaterhouse Cooper estimates that cash is used in 98% of consumer payments in India compared to 55% and 48% in the US and the UK, respectively. Given the strong reliance on cash and paper currency, the present move has thus to trade-off the immediate short-term pain against the likelihood of larger benefits over the longer run.

On how people trade off the instant with the future, an analogy from financial economics literature is instructive. It was Myron Gordon and John Lintner who propounded the bird-in-hand theory. They postulated that investors prefer dividends to capital gains. Capital gains are more risky and investors expect to be compensated by higher returns, which means it puts pressure on the management to deliver higher growth in the future, which may or may not happen. Based on responses to the prime minister’s app, an overwhelming majority of people in India, on the other hand, are willing to be patient and give the government’s gambit a reasonable chance. For the masterstroke to translate into reality, however, several initiatives need to be taken by the government. These have been extensively discussed in the media and include addressing the root of the curse of creation, i.e., flow of black money. Thus, simplification of tax laws, reducing the compliance cost of paying taxes, minimising discretionary powers in government decision-making, reform of institutions and, on top of the list, addressing campaign finance of political parties are all enablers.

For now, a temporary monetary disequilibrium exists implying that there is excess demand for currency or in other words a short supply of cash. Banks and financial institutions have been unable to cope in the backdrop of inadequate supply of new legal tender, aggravated by the wait to recalibrate ATMs to handle new notes. Economic theory posits that the adjustment to the new equilibrium will happen either through quantity rationing (reflected in serpentine queues) and/or price adjustment or both. There is anecdotal evidence of price adjustment coming in, too. The demonetised currency notes are occasionally selling for a discount while the yet-in-short-supply notes are attracting a premium. This should not surprise us Indians who, until the 1990s, were treated to long and arduous waiting lines for scooters and cars, to name just two sectors. We even paid a black market premium for what we now know were substandard products.

As the supply-side of the monetary machine adjusts, which it will, there is a lingering opportunity in the system. Demonetisation, they say, allows for a one-time detox of the existing system. Besides the governance and administrative reforms mentioned above that are necessary to cleanse the system, a move towards digital cash could act as a force multiplier in mitigating creation of black money.

The government has for long now dabbled with the idea of a cashless economy with the intent to counter the black money disease. In his 2015 budget speech, the finance minister mentioned as much. RBI’s Vision 2018 plan also aims to stimulate use of technology-based payment products. The government’s efforts to go cashless have ranged from champion attempts like the Unified Payments Interface (UPI) to incentivising credit/debit card payments through tax breaks and direct benefits transfer.

Reports indicate there is an increase in the use of cashless transactions. RBI data show that mobile wallet transactions jumped from R10 billion in 2012-13 to more than R490 billion in the year 2015-16 and the number of mobile banking transactions rose from 16.8 million in December 2014 to 39.5 million in December 2015. It is estimated that digital payments industry will reach $500 billion, contributing 15% to India’s GDP by 2020.

There has been an upsurge in mobile and electronic payment system usage recently, although the ticket size of such transactions remains relatively small. For example, the mobile wallet platform Paytm recent;y witnessed a record high 7 million transactions worth R120 crore in a day and Mobikwik registered a 7,000% increase in bank transfers post-demonetisation. Besides, Airtel has established the first Payments Bank with 10,000 retail outlets in towns and villages serving as banking points for customers and Vodafone India’s M-Pesa customers’ who can cash out from specified outlets has witnessed a 100% increase in its app download and the number of transactions has doubled. The financial architecture for m-payments has been around for some time and while its existence is necessary, it is not sufficient in the march towards a cashless society. You need merchants to invest in technology and people to adopt m-wallets. If the current demonetisation initiative serves as a trigger for behavioural change in society in favour of digital payments, it will provide the much needed shot in the arm for the industry and government. Once a critical mass is achieved in digital payments, inherent network effects will ensure a rapid and non-linear adoption. That is power of network effects in digital systems. And if successful, the new R2000 currency note will have even fewer takers in the future than now!

Rajat Kathuria,
Mansi Kedia
& Smriti Chandrashekar

Kathuria is director & CEO, Kedia is consultant, and Chandrashekar is research associate, ICRIER.
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