Demonetization in India: Step for Curbing Black Money

Had you gone to sleep a little early on 08^th November without catching on the news, you would have woken up on 09^th November morning realizing that all the 500 INR notes and 1000 INR notes in your wallet were actually worthless. Not exactly worthless, because you do not stand to lose anything in this case! You can always walk across to your nearest branch and deposit these 500 and 1000 notes into your account, but you can use them for transactions. Of course, there are restrictions on the amount you can withdraw over the next couple of weeks, but that is more in the nature of a temporary hiccup.

The demonetization of the 500 and 1000 notes was announced by the PM late on 08^th November. Both these denominations actually stopped being legal tender effective the midnight of 08^th November. Over the next 40 working days thousands of crore worth of these denominations will have to be surrendered to your bank. They can either be credited to your bank account or you can exchange them for smaller denominations, albeit within certain limits. But, why exactly did the government announce this demonetization measure with so much urgency?

Curbing black money, corruption and terror financing

The move to demonetize the 500 and 1000 notes is intended to actually hit three birds with one stone. Firstly, it is estimated that a large chunk of the black money in India is held in the form of these high denomination currency notes. This demonetization will force all this money to come into the formal banking system. Secondly, corruption and black money are closely related in a country like India. Corruption gets currency because it is very easy to exchange and hold on to high denomination notes in India. This demonetization will force all this money back into circulation in the economy. Thirdly, it is estimated that a large part of terror financing happens through counterfeit notes of 500 and 1000 denominations. This move to demonetize will make all this counterfeit money redundant and thus it also indirectly addresses the issue of use of counterfeit money for illegal activities.

It will also have a salutary economic effect

Apart from addressing the issues of corruption, black money and counterfeit money, this move to demonetize the 500 and 1000 denominations will also have a positive impact on the Indian economy overall. Firstly, this move will bring more people into the tax ambit. As per the Economic Survey 2016, India has a very low tax/GDP ratio of 16% which is lower than the average of 22% for emerging market economies and 34% for the OECD economies. Demonetization will widen and deepen the tax base in India. Secondly, this move will be a big push for digital inclusion. The current government has pushed Aadhar, Direct Benefits Transfer (DBT) and Jan Dhan to encourage financial inclusion. Forcing cash to come into the banking system will be one more step towards financial inclusion. Thirdly, India’s GDP and wealth may actually be much higher if the parallel economy is shrunk. After the Income Disclosure Scheme (IDS), demonetization is one more step in that direction.

Who needs to worry about an impact?

Even as the economy adjusts to the new scenario, there are few specific segments that may get impacted. Firstly, the average consumer who depends on ATMs to meet her daily requirements will surely put to inconvenience. Also the task of surrendering your cash to the bank within the next 40 working days will be quite a task. Secondly, this move will hit small and mid-sized businesses. Many small entrepreneurs and traders who operate out of semi-urban and rural areas still rely on cash as a medium of exchange for their transactions. This is because banking facilities are not fully developed in these areas to the extent it is spread out in cities. They will surely be put through hardships. Thirdly, sectors that transact predominantly in cash will also be affected by this move. Sectors like cement, construction, real estate development and jewellers principally transact in cash. These sectors could see a contraction in demand in the short term. The impact is already visible in the way these stocks corrected on 09^th November.

Are there any open issues about the demonetization move?

• If the purpose behind the demonetization was to eliminate black money, it is not clear why the government plans to replace the 1000-INR note with a 2000-INR note. That is not too clear at this point of time.
• Most Indian banks are already overworked. When banks open on 10^th November, the question is whether they can handle the pressure of thousands of billions of these high denomination notes coming into the bank.
• There are assembly elections coming up in key states like Punjab and Uttar Pradesh. It is normally seen that the money in circulation goes up sharply during election time. What impact this move could have on the outcome of these elections is still not very clear.
• As most experts say, cash is just the symptom and not the problem. Black money is held in various forms like land, property, gold and even in the form of diamonds and art. How those will be addressed is the moot question.

The government has taken a step in the right direction. Curbing black money was long called for. How it handles the logistics over the next few weeks could be extremely critical.