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Demonetisation - Long-Term Effects, Part I - Outside View by Nitin Gregory

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Demonetisation - Long-Term Effects, Part I
Dec 2, 2016

A medium of exchange.

That's the generally accepted definition of money. The simplicity of it belies the importance of 'hard' cash in a transaction-based economy. Developed economies like Sweden have abandoned paper money. Meanwhile, India's economy is still 95% cash. And any changes to the nation's money will affect a large majority.

It is three weeks since the announcement of 'demonetisation'. Reaction has been mixed. The execution has been questioned. But things seem to be getting back to normal. We all hope that the coming weeks will see some pressure come out of the system.


Many nations have employed 'demonetisation' before - including India...twice!

The previous episodes had some similarities. They were also aimed at 'black money', veiled in secrecy, and resulted in long queues.

The differences, though, are more interesting.

For one, unlike current RBI governor, Urijit Patel, the RBI governors who presided over past demonitisations were not impressed. Governor IG Patel, during the 1978 demonetisation, said 'such an exercise seldom produces striking results'.

Another big difference this time is the impact on the common man. Removing the Rs 1000 note in 1978 would be like removing an Rs 10,000 note today (assuming 6% inflation). Very few individuals were using such high-value notes in 1978.

Balance of benefits

Demonitisations has costs and benefits. The costs are fairly obvious today. Demonetising 86% of the cash in a cash-dominated economy means a disruption to daily transactions. And the pain is worse in the rural economy. For example, how will daily wage labourers be paid? There is also the cost of printing new notes and administering the transition period.

Black money is gone?

'Black money' is money acquired illegally or that has evaded tax. Demonitisation is tipped to attack the 'black money' hoarders (similar to the two previous moves). However, an analysis of IT raids from 2012 shows that only 6% of 'black income' is stored in cash.

In other words, the primary storage mechanism for black income is not cash - it's real estate, stocks, and gold. Even in the 1946 demonetisation, only 6% of the currency value in issue did not make it back into the banking system. The government then was expecting a large chunk of the currency not to be deposited back into the system (illegal income that is not declared). However, it turned out only 6% of the value was not deposited back in the system.

A noted economics professor has estimated the amount of black cash (black money sitting as cash) in the system to be three lakh crore, which is roughly 18% of the cash in issue but only 3% of the 'black income' generated in India every year. This means that every year even more black income is generated. The estimated amount that can be netted is only 3% of the yearly generation!

Okay, well, let's assume the move creates a 'reset' and the existing black money is rendered useless. The question remains - what will curb the future creation of illicit income?

Counterfeit countered?

Another stated reason for demonitisation is to clamp down on fake notes. A 2015 study by the Indian Statistical Institute (ISI) estimates that only 400 crore of fake money is in circulation - far too little to warrant demonitisation. And even if the move does suck out the fake notes, what will prevent the creation of new fakes?

The other ancillary benefits stated like a push towards a digital economy remind me of Marion Antoinette - 'no cash? Let them have digital wallets'. An estimated $700 Million people live on less than $3 per day - Is a 'digital wallet' or a new e-payment app really their first priority? Is this the key obstacle towards growth and increased purchasing power? The key drivers for fast growing economies are mentioned here.

However, the centerpiece will remain the black economy. This leads us to believe there will be further measures to tackle the source of the 'black money'.

Demonitisation sends a strong signal to the economy that there is political will to tackle 'black money'. But to truly stamp out the problem, the government will have to take action on the sources of illicit income, not just the cash component.

More in this later...

This column is authored by Nitin Gregory. Nitin, who graduated from IIM-Calcutta, is currently pursuing a finance role with an automotive major. He has a deep interest in Macroeconomics and pens a blog at Gregonomics.


The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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