Demonetisation and Its Implications for India

Demonetisation is a radical monetary step in which a currency unit is declared as an invalid legal tender. This is usually done whenever there is a change in the national currency of a nation. Such a step is especially taken to curb the menace of counterfeiting, black money and money laundering. A recent example is demonetisation of 500 and 1000 denomination currency units in India. Another example of demonetisation is when the European Monetary Union nations decide to adopt Euro as their currency. Other countries like Zimbabwe, Fiji, Singapore and Philippines have also opted for currency demonetisation in the past.

Why is this scheme introduced?

On November 8, 2016 Prime Minister announced that Rs 500 and Rs 1000 denomination notes will become invalid and all notes in lower denomination of Rs 100, Rs 50, Rs 20, Rs 10, Rs 5, Rs 2 and Re 1 and all coins will continue to be a valid legal tender. He also added that new notes of Rs 2,000 and Rs 500 will be introduced. There was also no change effected in any other form of currency exchange like cheque, Demand draft (DD), payments made through credit cards and debit cards.

The move was taken to curb the menace of black money, fake notes and corruption by reducing the amount of cash available in the system. It has been observed that the fake Indian currency notes of higher denomination have rapidly increased making it difficult for ordinary citizens to distinguish them from genuine notes. These fake notes have been heavily misused by terrorists for anti-national and illegal activities. Since India is largely a cash based economy, containing the circulation of black money and fake notes requires the introduction of schemes like this.

Was this the first time the government is demonetising?

No, this is not the first time the government is following the policy of demonetisation of high-value currency. The first instance of demonetisation by the government was implemented in 1946 when the RBI demonetised Rs 1,000 and Rs 10,000 notes. Later, higher denomination bank notes (Rs 1000, Rs 5000 and Rs 10000) were re-introduced in 1954. However, Morarji Desai government demonetised these notes in 1978. According to data provided by RBI Rs 10,000 note was printed in 1938 and 1954 and was subsequently demonetised in 1946 and 1978 respectively.

Why the government has banned Rs 500 and Rs 1000 notes?

The rationale behind banning Rs 500 and Rs 1000 notes is that unaccounted money used in corruption or any deals takes place in the form of high-value notes of Rs 500 and Rs 1000 bills. These higher denomination notes are often found to be used for funding terrorism and corruption. The Financial Action Task Force (FATF), a global body that monitors the criminal use of the international financial system has observed that high-value currency units are often used in money laundering schemes, racketeering, and drug and people trafficking. In addition, these notes constitute a huge percentage of money spent during general elections by political parties, candidates in India. While the official spending was put up as only Rs 7,000-Rs 8,000 crore during the 2014 general elections, the corresponding figure released by the Centre for Media Studies shows that nearly Rs 30,000 crore was spent in the 2014 general elections.

What are the implications of this move on various stake holders?

Parallel economy

Demonetisation will curb the parallel economy as the owners of black money will not be in a position to deposit the money with them in the banks. It is likely to temporarily stall the circulation of large volume of counterfeit currency and prevent funding for anti-social activities like smuggling, terrorism, espionage etc.

The above sectors are expected to face the most significant impact of the demonetization process.

GDP

With the reduction in the consumption demand, GDP formation in the country could get adversely impacted. Demonetisation has led to a decrease of 1% in country’s GDP growth. However, the sluggishness is expected to be less significant as the demand will re-enter the system once the situation becomes normal.

Banks

This move will increase the amount of money deposited in Savings and Current Account of commercial banks. Even most of the Jan Dhan accounts which were lying idle for months have seen some deposits. This will enhance the liquidity position of the banks and can be utilized by it for lending purposes. But on the flip side, as households held these money to meet emergency situations, it is expected that there would be withdrawals from these accounts at later stages.

Online transactions and other modes of payment

There will be a surge in the online transactions and other modes of payment. E-wallets, digital transaction systems, e-banking, usage of plastic money are expected to see increase in demand. Eventually this should lead to strengthening of these systems and the concerned infrastructure.

RBI

Demonetisation has reduced the RBI’s profits. As a result, the government received a lesser dividend from the central bank. RBI had transferred a meagre Rs 30,659 crore as dividend to the government in 2016-17, which is less than half of what it usually gives.

Why Rs 2,000 note has been issued if the objective is to combat black money and corruption by removing large value notes?

It is felt that the small businesses and India Inc still needs to use cash and in such cases Rs 2,000 denomination notes would come handy. The government has added that the central bank would cautiously monitor and regulate the issuance of Rs 2,000 notes in the system. So, it is expected that the Rs 2,000 notes will not be issued in large numbers.

Is the idea of demonetising higher value notes new?

The idea of demonetisation is not unique or new. It has been advocated in the past few years by various think-tanks and international bodies to curb the menace of tax-evasion, terrorism financing etc. in the beginning of this year, head of European Central Bank, Mario Draghi announced that the bank is thinking to abolish the region’s most-valuable bank note, the 500 euro bill in order to curb tax evasion and terrorism financing. Similarly, former US treasury secretary Larry Summers has also called for the demonetisation of $100 bill.

What are the pros of this move?

Less Cash Economy

• 21% reduction in currency circulation has been witnessed in the economy.
• The economy’s entire cash holding now has an address. It no more remains anonymous.

Impact on Black Money

• Demonetisation will act as a boost for the formal economy in the long run as black money hoarders will not able to make their money white.
• After demonetisation, advance tax by non-corporate in the current fiscal has increased by 42%.
• Government had detected 3 lakh shell companies. It has deregistered 2.1 lakh shell companies.
• SEBI has delisted 450 suspicious companies.
• Undisclosed income to the tune of Rs 15,497 crore has been admitted in 2016-17. 44% increase in undisclosed income detected.
• The income tax department’s Operation Clean Money carried out in two phases to probe tax profiles of individuals which were found to be inconsistent with the cash deposits made by them during the demonetization period. The operation helped in unearthing huge amount of black money.

Widening of tax base

The tax base has widened. The number of e-returns filed till Aug 5 has seen an increase of about 25.3%. Similarly, the total number of all returns (electronic+ paper) has also seen an increase of 17.3% compared to 2015-16.

Rightly, the Economic Survey (Volume II) 2016-17 has pointed out that the growth in tax payers post demonetisation was significant.

Direct taxes have gone up significantly.

Demonetisation along with the implementation of GST is likely to make the system more efficient, accountable and transparent.

Impact on Interest rates

Post demonetisation, lending rates of banks has seen a reduction of around 100 basis points.

Shift in Savings

• Assets under mutual funds have witnessed massive increase. It rose to Rs 20 trillion at the end of July.
• The insurance premium collections have seen double-digit growth.

Digital Payments

• Total value of digital transactions has increased tremendously. Transactions worth Rs 83,800 crores were carried out in 2016-17. In 2015-16, the corresponding value was Rs 48,800 crore.

EPF and ESIC

Post demonetisation, more than 1 crore workers have been added to EPF and ESIC systems.

Impact on Security Situation

Reduction in naxal activities and stone pelting incidents in Jammu & Kashmir.

Fake Currency

Increased detection of fake currencies. For instance, seized fake Rs 1000 notes have nearly doubled.

Discussion

Though, the move is likely to hurt the working class, small and rural businesses in the short term, it will not hurt the individuals in the long term. According to economist Ajit Ranade’s calculation, the highest face value of currency units in India should be only Rs 250. This is what most Indian individuals need. So, the issue of Rs 2000 notes casts suspicion over the effectiveness of this move in the long run. Government does not have any fair estimate of how much of black money is in the forms other than physical notes like gold, jewellery, land etc. The present move of the government is not likely to affect the other forms of black money. The move will also have little effect on the black money stashed away in the foreign tax havens. But as the government has argued that the idea behind demonetisation was not just to root out black money but also to increase transparency, digitisation, tax base, minimize the cash transactions in the economy as well as to curb terror funding.