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Demonetization – A Potentially Powerful Stick That Needs Carrots Now


Reverse Helicopter Drop – a classic of terming the demonetization event in 3 words or to make it more brutal Demonetisation: To Deify or Demonize? – this is how the Economic Survey 20167-17 released by the Department of Economic Affairs terms the chapter on Demonetization.

What is Demonetization?

Every currency note issued by the government is legal tender for all debts, public charges, taxes, and dues. Demonetization is a method where the government deprived certain notes of their legal tender status, except for specified activities (such as paying utility bills). While only two currency notes were denomentized, they constituted 86% of the total value in circulation.

What was the aim of this action?

There was a fourfold reason:

  • Curb corruption;
  • Curb counterfeiting
  • Stop the use of high denomination notes for terrorist activities; and
  • Stop the accumulation of “black money”, generated by income that has not been declared to the tax authorities.

Why was this done?

Because all previous actions taken were either ineffective or too late like the creation of the Special Investigative Team, Introduction of the Black Money and Imposition of Tax Act 2015; Benami Transactions Act 2016 clubbed with the inefficient agreements with Switzerland and the tax treaties with Mauritius, Cyprus and Singapore. While these became old, the government demonetized these actions with the Income Disclosure Scheme.

Not the first time right, then why the stumble?

While we have had two previous actions of demonetization which took place in in 1946 and 1978, in neither of those times did the currency notes that were removed constitute so high a number as percentage of circulation and hence the impact was pretty grounded.

Facts / Opinions in the background.

  • The value of high denomination notes (INR 500 and INR 1000) relative to GDP has also increased in line with rising living standards. India’s economy is relatively cash-dependent
  • Cash holdings were not being used for legitimate transactions, but perhaps for other activities such as corruption. Income becomes black solely because it has not been declared to the tax authorities.
  • High value notes are associated with corruption because they are easier to store and carry, compared to smaller denominations or other stores of value such as gold.
  • Extent to which Rs 500 and Rs 1000 notes are used for transactions comes from data on “soil rates”
    1. The rate at which notes are considered to be too damaged to use and have been returned to the central bank.
    2. As per RBI data, soil rate of low denomination notes is 33% per year while for Rs. 500 it is 22% and for Rs. 1,000/- it is 11%.
    3. Black money estimates that the soil rates are in direct co-relation to the usage rate – the higher the usage – higher the soil rate.
    4. Based on this, the estimate of money that is not used for transactions at Rs. 7.3 lakh crores
    5. Take the relative soil rates for the US $50 and $20 notes. If the soil rates for those are applied to Indian high denomination notes, the estimate is about Rs. 3 lakh crore – the amount not used for transactions.

Where did we go wrong?

While 86% of the currency was removed at one stroke, the alternative for those holding the currency to exchange for new notes / smaller currency notes was highly inadequate. This meant long queues at banks and empty ATM’s which continued for quite a while.
Government has as of yesterday removed the limit on how much of an amount could be withdrawn from ATM’s and Current Accounts while weekly limits still exist for those holding savings accounts. The suddenness of the action combined with the enormous impact on the common man has meant a slowing down of the economy. The Economic Survey puts the damage (slow down) at between 0.25% to 0.50%.
Ok. Lets’s move to the good stuff.

What are the benefits of this?

Given the cash crunch and the requirement of cash in everyday life, one positive impact was on the usage of plastic money. Card usage went up sharply as also usage of other alternatives like wallet based apps. How far this shall continue is a matter of speculation though the government is trying to push more people to transact through digital mediums since it provides a clear audit trail and makes tax evasion tougher.

What next?

  • Once the cash supply is replenished, which should largely be achieved by end-March 2017, the economy should revert to normal, perhaps even with a bounce reflecting reversion to the mean.

In summary this is what the government believes

Demonetisation has been a radical, unprecedented step with short term costs and long term benefits. The liquidity squeeze was less severe than suggested by the headlines and has been easing since end-December 2016. A number of follow-up actions would minimize the costs and maximise the benefits of demonetisation.
These include: fast,demand-driven, remonetisation; further tax reforms, including bringing land and real estate into the GST, reducing tax rates and stamp duties; and acting to allay anxieties about over-zealous tax administration. These actions would allow growth to return to trend in 2017-18, following a temporary decline in 2016-17.


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