The decision to demonetise notes of higher denominations is undoubtedly one of the biggest shocks the Indian monetary economy has received under the Narendra Modi government’s reign.
There are many who hail this step as one that will bring a decisive end to black money, or wealth unaccounted for, in India, while others believe the cost to the economy, in terms of disruption to spending, would outweigh the benefits.
As the debate rages on, it is worth looking at earlier such attempts to understand its likely effects.
The demonetisation of high denomination notes was carried out in India during the 1970s on the advice of the Wanchoo committee report. In 1978, the Rs1,000, Rs5,000, and Rs10,000 notes were withdrawn from circulation in an attempt to curb illegal activities.
This move was criticized as being ineffective because the notes that were pulled out comprised only about 2% of the total currency in circulation, according to an editorial in The Economic & Political Weekly magazine. Moreover, it was pointed out that very little of ill-gotten wealth was in cash, as their holders would be investing in assets such as land and gold. The fact that we are still discussing black money in 2016 is commentary enough on the efficacy of the measure.
In other parts of South Asia too, demonetisation has been ineffective, and sometimes downright harmful, for the economy and common man. For instance, the Myanmarese government repeatedly resorted to this measure in the past. The state’s authoritarian nature led to profound hardship for the citizenry following such moves and provoked a backlash.
Demonetisation in Myanmar (formerly Burma) was first resorted to in 1964, and the later on in 1985. The aim was the same as the Modi government’s: curb illegal transactions outside the realm of the formal economy. Cash holdings above a certain limit could be exchanged for legal tender for a fixed time period, but beyond that, tax and investigative measures were imposed to weed out black-marketeers. So, such entities used proxies to exchange the money on their behalf and this led to a further round of demonetization by Myanmar in 1987.
This time, though, the money could not be exchanged, rendering nearly three-fourths of the country’s cash circulation worthless.
Protests erupted, accompanied by a deep-seated animosity for the banking system, and a further preference for land and gold over investing in the financial system. The recent decision by the Central Bank of Myanmar to introduce a new 10,000 kyat note to prevent forgery has been met with suspicion due to this history of de-monetisation, rendering monetary policy problematic.
This time, the coordinated rollout of the new Rs500 and Rs2,000 notes would prevent problems that were seen in Myanmar. However, the scheme would only be as good as its implementation.
A criticism leveled against the 1978 move holds true even today: De-monetisation would wipe out the stock of ill-gotten wealth held in cash, while doing nothing about the wealth that has been converted to assets like land and gold. This measure does not tackle money laundering, but only penalizes those who have been lax in ensuring such conversion. Further, it does not prevent the future build-up of black money.
If de-monetisation is resorted to again, it could result in the public losing faith in the system. De-monetisation might be effective, no doubt, but is an extremely blunt instrument, effective insofar as the target shows no dynamism and ability to change.
The other major problem relates to the amount of cash in the system. India has one of the world’s highest cash-to-GDP ratios—nearly 12% as compared to around 3.9% in Brazil and 3.7% in South Africa. Notes of Rs500 and Rs1,000 denominations formed nearly 10% of nominal GDP in 2015-16, based on calculations using RBI data. The extent of illegal wealth affected depends on how much of the stock of currency actually represents illegal wealth. The problem is, no one knows for sure.
Proponents of the measure argue that it will make current policy more effective against the black market than the 1978 experiment since today the Rs500 and Rs1,000 denominations comprise nearly 80% of the total stock of currency.
The measure is an effective shock to 10% of the GDP, which is massive in economic terms. Holders of the currency would be able to exchange it for the newly-legal tender but the transaction costs involved would determine how much of an effect it would have on the economy. As long as old notes remain in public hands, consumer spending would be affected, spelling severe problems for both low-income producers and consumers.
Moreover, for those in areas not served well by the banking system, the cost of exchanging their money for legal tender could be extremely high. Speed is necessary to prevent black-marketeers from escaping. However, if the process is too fast, many might lose out on legitimate wealth holdings. This was seen in Zimbabwe, which resorted to demonetization in 2015 to tackle hyper-inflation.
Demonetisation of such an extent in an economy as reliant on cash as India is fraught. Do it too fast and legitimate wealth gets destroyed. Too slow and the objective won’t be achieved. Even if illegal wealth is wiped out, if the consumer economy is disrupted, it might have an effect of fuelling mistrust in the banking and formal economic system.
It is too soon to tell the impact. The lessons of history, though, provide a clue.
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