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Narendra Modi’s most disruptive economic step till date has unleashed a furious debate among economists

India-Rs 500-Rs 1000-Bank-ATM-Reserve Bank of India
AP Photo/Bikas Das
Torn apart.
By Madhura Karnik, Manu Balachandran
Published Last updated This article is more than 2 years old.

It has been a rough week for millions in India.

Eight days after the Narendra Modi government decided to demonetise 86% of India’s currency notes by value, many are still braving the heat and cold waiting outside thousands of ATMs across the country, many of which have gone dry. Indian banks, of course, were caught unaware.

So far, some 33 people have died, mostly owing to exhaustion from standing in long queues.

Cash transactions, on which Asia’s third-largest economy are still heavily dependent, have virtually come to a standstill and the country’s GDP is expected to take a hit in the current quarter.

So far, 33 people have died, mostly owing to exhaustion from standing in long queues.

While some economists say this short-term pain is tolerable because it would benefit the economy in the long run, critics say banning the most popular currency notes won’t address its intended purpose. Modi’s main aim is to weed out black money—unaccounted wealth—that accounts for 20% of GDP.

Detractors have slammed the lack of planning—the liquidity crunch remains quite severe—and have raised doubts about whether such a move will really kill the counterfeit currency market, besides the black money market, since those hoarding wealth are more likely to hold it in real estate or gold, rather than in currency.

Will it wipe out black money?

The complete financial overhaul comes after 66-year-old Modi promised to weed out corruption and illegal wealth as part of his election manifesto.

“To break the grip of corruption and black money, we have decided that the 500 rupee and 1,000 rupee currency notes presently in use will no longer be legal tender from midnight tonight, that is 8th November 2016,” the prime minister had said.

Within hours, critics were questioning its efficacy.

“Actually, the very premise that demonetisation will help in removing the (black money) menace is wrong. That’s because people don’t stack black money in cash. Rather, they stash it in undisclosed accounts in Swiss banks. So demonetisation won’t affect the big fish,” said Abhirup Sarkar of the Indian Statistical Institute (ISI).

But those supporting the move, such as former chief economic advisor Arvind Virmani, say that one must not consider this move in isolation but also take into account other measures. The Modi government had brought in some sweeping reforms, including the black money bill, real estate regulation bill, and the goods and services tax (GST) over the past few years.

Four days after Modi’s announcement, Surjit Bhalla, chairman and managing director of Oxus Investments, a New Delhi-based economic research, asset management, and emerging-markets advisory firm, said the step could become an even bigger reform than GST.

“Most of the spending of this black money is for expenditures on gold, purchase of foreign exchange, and purchase of real estate. Transfer of money abroad into ‘anonymous’ accounts is now a difficult exercise for all the world’s black money residents. Gold purchases and hoarding are also becoming more difficult. So, the prime outlet for big-time black money use is real estate,” he wrote in the Indian Express newspaper.

Meanwhile, the real estate market has also taken a hit since demonetisation. Here is what Vivek Dehejia, an associate professor of economics at Carleton University in Canada, had to say in Swarajya magazine.

“A crash in property prices, induced by demonetisation, will indirectly affect the wealth of those who have parked money, whether illicit or otherwise, in the property market… it would be hard to deny that those with large stashes of unaccounted cash are going to take a hit in the short run, and it will take a period of months, if not years, for an equivalent stock of black money in the newly-printed currency notes to be built up.”

Is there going to be a $45-billion kitty?

Immediately after the government announced the demonetisation drive, Mumbai-based brokerage firm Edelweiss Securities Ltd said that the move would unearth $45 billion in black money.

“This money can now get utilised for various economic reforms’ funding,” Edelweiss analyst Manoj Bahety had said.

Madan Sabnavis, the chief economist at CARE Ratings, however, reckons that banks have certainly earned more than $45 billion in deposits already. But as far as flushing out black money and bringing it into the economy is concerned, he isn’t entirely sure. ”Nobody has any idea about how much money is there in the system,” added Sabnavis. “It is only a guess as far as the impounded cash is concerned.”

Sabnavis has meanwhile pointed out that in the short run, India’s GDP is likely to take a hit. “What will happen is that as the liquidity crunch happens, the services sector will be affected. Almost 60% of India’s GDP is dependent on (the) service sector… Even in the agriculture sector, there will be some pressure in the short term.”

“We should not automatically assume a bonanza for the government’s coffers.”

There are also others who believe expecting $45 billion in black money to enter the system may be far-fetched.

“I think, as some have argued, that it is very likely that the Reserve Bank of India will continue to count the estimated $45 billion in outstanding notes as a liability on its books,” Milan Vaishnav of the Carnegie Endowment for International Peace said. “The desire of the government to claim a massive special dividend has to be pitted against the need to maintain the rupee’s credibility. We should not automatically assume a bonanza for the government’s coffers.”

Counterfeit currency

Modi’s big gamble was also aimed at taking on the growing counterfeit currency market in India. According to estimates, a little over Rs70 crore of counterfeit notes enter the Indian economy annually.

“Enemies from across the border run their operations using fake currency notes,” Modi had said on Nov. 08. “This has been going on for years. Many times, those using fake 500 and 1,000 rupee notes have been caught and many such notes have been seized.”

Arvind Virmani agrees that the step could be a ”blow to cross-border counterfeiters.”

However, economists such as Rajiv Biswas, Asia-Pacific chief economist at IHS Markit, say that Modi’s steps won’t really make sense to end the use of counterfeit money.

“Sadly the argument that counterfeit money will be wiped out is going to be very short-lived, as counterfeiters worldwide have shown high levels of sophistication and ability to rapidly reproduce the latest banknotes,” said Biswas. “This has even occurred in the EU where the European Central Bank has very advanced technology for producing Euro banknotes. Therefore, it is likely that counterfeit new banknotes will soon proliferate. So how will the government respond—will it demonetise again every six months?”

The new currency does not come with any new security features, according to a report published last week in The Hindu newspaper, and carries forward features from the old notes.

“Counterfeit currency is going to be flooding the Indian market in the next day or two,” Prabhat Patnaik, economist and professor emeritus at Jawaharlal Nehru University, said on Nov. 12. “We have been having old currencies disappearing, new currency notes coming into being. We had a time when we had aanas and paisas and so on but these days we don’t. So a change of that kind, where existing currency notes have been phased out, is something which will anyway get rid of the current counterfeit notes.”

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