Recent Demonitisation in India

Recent Demonitisation in India
Dr.Debesh Bhowmik

What is demonitisation

Demonetization is the act of stripping a currency unit of its status as legal tender. Demonetization is necessary whenever there is a change of national currency. The old unit of currency must be retired and replaced with a new currency unit.

There are multiple reasons why nations demonetize their local units of currency. Some reasons include to combat inflation, to combat corruption, and to discourage a cash system. The process of demonetization involves either introducing new notes or coins of the same currency or completely replacing the old currency with new currency.

During the regimes of silver standard and gold standard and even in bimetallic standard,the nature of demonitisation in various countries were rather different.

Gold was demonetized in stages, first by FD Roosevelt in 1933, who confiscated (stole) the American people’s Gold and gave them paper in return… at the rate of $20.67 /oz… Then in a few months he marked up the value of the Gold (that is, devalued the paper given to the people) to $35.00 / oz.; a loss of more than 50% of value in a few months. On 6 March 1933, soon after he took office, President Roosevelt declared a nationwide bank moratorium for four days to stop heavy withdrawals and forbade banks to pay out gold or to export it. On 5 April the president ordered all gold coins and gold certificates in hoards of more than a hundred dollars turned in for other money. The government took in $300 million of gold coin and $470 million of gold certificates by 10 May.
The demonetization of Gold was completed by Nixon in 1971, when he ‘closed the Gold window’… that is, reneged on the US commitment to redeem every thirty five US Dollars for one oz. of Gold, as per the Bretton Woods agreement. Gold was demonetized fraudulently; the honest approach would have been to devalue the Dollar, to balance all newly printed Dollars against physical Gold reserves. Already the EU has ‘demonetized’ the 500 Euro bill, and Citibank in the US has stopped accepting cash (Dollars; legal tender for all debt, public or private).Then $100 Dollar bill was under imminent threat.
Indian History
In the history of Indian monetary system,demonitisation of silver,gold and their currencies occurred frequently.
In 1835, a declaration from Governor-General William Bentinck in Calcutta demonetised all old gold coins and introduced a unified coinage system for India with the Madras silver rupee as the standard. The gold mohur (coin) of the Mughal empire was deliberately undervalued to dissuade its usage, and soon its circulation began to fall. In 1841 came another proclamation authorising the government to receive gold, but it continued to pay out only silver.Gold mohars were accepted in public treasures at the rate of 1:15.Even under the regime of silver standard,in 1874,government adopted gold currency.In 1893,gold and silver coinage were no longer legal tender and government introduced gold exchange standard in stead of gold standard in India by British government where gold standard was the monetary system,even in its territories gold standard were  the system.
Demonitisation in India and foreign countries

·  The sudden move to demonetize Rs 500 and Rs 1,000 currency notes is not new. Rs 1,000 and higher denomination notes were first demonetized in January 1946 and again in 1978.

·  The highest denomination note ever printed by the Reserve Bank of India was the Rs 10,000 note in 1938 and again in 1954. But these notes were demonetized in January 1946 and again in January 1978, according to RBI data. Rs 1,000 and Rs 10,000 bank notes were in circulation prior to January 1946. Higher denomination banknotes of Rs 1,000, Rs 5,000 and Rs 10,000 were reintroduced in 1954 and all of them were demonetized in January 1978.

In recent times,outside India,there are a few examples of demonitisation.

In 1982, Ghana rolled out the decision to demonetise their 50 cedi currency notes in order to monitor money laundering and corruption. The change was not welcomed warmly, creating chaos across the country and finally resulted in a move back to physical assets and foreign currency.
Nigeria’s economy collapsed after the 1984 demonetisation move that did not go as planned. The military government of then President Muhammadu Buhari introduced different coloured notes to invalidate their old currency in order to fight black money.
Around 80% of Myanmar’s currency was demonetised in 1987 by the military to curb black money, but the move resulted in a lot of protests and the country witnessed several killings.
Under the governance of Mikhail Gorbachev in 1991, the then Soviet Union demonetised the higher denominations of ruble bills, the 50s and 100s. The move did not go well and resulted in takeover of Mikhail’s leadership within eight months of the plan.
North Korea faced demonetisation of their currency in 2010, which led to major economy breakdown with people left to starve for basics.
Zimbabwe once had hundred trillion dollar note, which was demonetised and was exchanged in a mocking way dropping trillion dollars to $0.5 dollar.

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.
Advantages of Demonetization

1. The biggest advantage of demonetization is that it helps the government to track people who are having large sums of unaccounted cash or cash on which no income tax has been paid because many people who earn black money keep that money as cash in their houses or in some secret place which is very difficult to find and when demonetization happens all that cash is of no value and such people have two options one is to deposit the money in bank accounts and pay taxes on such amount and second option is to let the value of that cash reduced to zero.
2. Since black money is used for illegal activities like terrorism funding, gambling, money laundering and also inflating the price of major assets classes like real estate, gold and due to demonetization all such activities will get reduced for some time and also it will take years for people to generate that amount of black money again and hence in a way it helps in putting an end this circle of people doing illegal activities to earn black money and using that black money to do more illegal activities.
3. Another benefit is that due to people disclosing their income by depositing money in their bank accounts government gets a good amount of tax revenue which can be used by the government towards the betterment of society by providing good infrastructure, hospitals, educational institutions, roads and many facilities for poor and needy sections of society.
4. Demonetization would lead to generation in employment. Government can now lend massively to infrastructure sector through the recapitalized Public Sector Banks. This would generate a lot of employment opportunities thereby moving more people out of poverty.

5.      In the long run,demonitisation has positive impact in the economy. It will boost the formal economy in the long run as black money hoarders will not able to make their money white. Middle class citizens may get benefitted from the short term fall in real estate prices. This move along with the implementation of GST is likely to make the system more efficient, accountable and transparent.

Disadvantages

1. The biggest disadvantage of demonetization is that once people in the country gets to know about it than initially for few days there is chaos and frenzy among public as everybody wants to get rid of demonetized notes which in turn sometimes can lead to law and order problem and chaotic situation especially in banks and ATMs which are the only medium to change the old currency units to new currency units.
2. Another disadvantage is that destruction of old currency units and printing of new currency new units involve costs which has to be borne by the government and if the costs are higher than benefits then there is no use of demonetization.
3. Another problem is that majority of times this move is targeted towards black money but if people have not kept cash as their black money and rotated or used that money in other asset classes like real estate, gold and so on then there is no guarantee that demonetization will help in catching corrupt people.

4.      Agriculture & allied sector, small traders, SME, services sector, households, political parties, professionals like doctor, carpenter, retail outlets, utility service providers etc have been facing huge disruptions. 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. However, the sluggishness is expected to be less significant as the demand is only got deferred and will re-enter the system once the situation becomes normal.

5.      Demonetization is not a big disaster like global banking sector crisis of 2007; but at the same time, it will act as a liquidity shock that disturbs economic activities.

6.      liquidity shock started which means people are not able to get sufficient volume of popular denomination especially Rs 500.  This currency unit is the favourable denomination in daily life. It constituted to nearly 49% of the previous currency supply in terms of value.

7. Most active segments of the population who constitute the ‘base of the pyramid’ uses currency to meet their transactions. The daily wage earners, other labourers, small traders etc. who reside out of the formal economy uses cash frequently. These sections will lose income in the absence of liquid cash. Cash stringency will compel firms to reduce labour cost and thus reduces income to the poor working class.

There will be a trickle up effect of the liquidity chaos to the higher income people with time.

        [i] Consumption will be hit: When liquidity shortage strikes, it is consumption that is going to be adversely affected first. 

Consumption ↓→ Production ↓→ Employment ↓→ Growth ↓→ Tax revenue ↓

[ii] Loss of Growth momentum- India risks its position of being the fastest growing largest economy: reduced consumption, income,      investment etc. may reduce India’s GDP growth as the liquidity impact itself may last three -four months.

[iii] Impact on bank deposits and interest rate: Deposit in the short term may rise, but in the long term, its effect will come down. The savings with the banks are actually liquid cash people stored. It is difficult to assume that such ready cash once stored in their hands will be put into savings for a long term. They saved this money into banks just to convert the old notes into new notes. These are not voluntary savings aimed to get interest. It will be converted into active liquidity by the savers when full-fledged new currency supply take place. This means that new savings with banks is only transitory or short-term deposit. It may be encashed by the savers at the appropriate time. It is not necessary that demonetization will produce big savings in the banking system in the medium term. Most of the savings are obtained by biggie public sector banks like the SBI. They may reduce interest rate in the short/medium term. But they can't follow it in the long term. 

There is no doubt that the rate of growth of GDP in the near term will be affected. Around 80 percent of our GDP is contributed by small businesses and demonetisation has affected the liquidity of these businesses in the short term and will remain impacted till all the abrogated notes are replaced. It is estimated that 20 percent of the GDP is contributed by black money, out of which the cash component is around 4-5 percent and the remaining contributions coming from benami properties, gold and other asset classes. If we believe these statistics then the impact on GDP also will be limited. One can therefore conclude that the impact on GDP will be limited and for a shorter duration. The success of this move depends on the amount of impounded currency which will be exchanged or deposited with the banks. The government expects that only around 80 percent of the impounded currency will be returned and the remaining forfeited by the black money holders. If the amount of currency returned or exchanged is in the vicinity of 93-95 percent then the gamble of the government would backfire, though in such an event the effect on GDP would be minimal.

Some Remarks

Nobel Laureate Amartya Sen has called the Narendra Modi government’s demonetisation move “despotic action that has struck at the root of economy based on trust.”
“It (demonetisation) undermines notes, it undermines bank accounts, it undermines the entire economy of trust. That is the sense in which it is despotic,” Prof. Sen told to a TV channel.
He further said his immediate point of view on demonetisation is on its economic aspect.
“It’s (demonetisation) a disaster on economy of trust. In the last 20 years, the country has been growing very fast. But it is all based on acceptance of each other’s word. By taking despotic action and saying we had promised but won’t fulfil our promise, you hit at the root of this,” Prof. Sen said.

“Telling the public suddenly that the promissory notes you have, do not promise anything with certainty, is a more complex manifestation of authoritarianism, allegedly justified — or so the government claims — because some of these notes, held by some crooked people, involve black money. At one stroke the move declares all Indians — indeed all holders of Indian currency — as possibly crooks, unless they can establish they are not,” Amartya Sen said in an interview with The Indian Express. Amartya Sen said the demonetisation drive has only caused inconvenience to common man who are deprived of their money even if it was earned legally. “Only an authoritarian government can calmly cause such misery to the people — with millions of innocent people being deprived of their money and being subjected to suffering, inconvenience and indignity in trying to get their own money back,” said Amartya Sen.

Rejecting government’s claim that the demonetisation drive will help to curb black money, Amartya Sen said it will be another failure of Narendra Modi government. Amartya Sen said, “It is hard to see how. This will be as much of a failure as the government’s earlier promise of bringing black money stacked away abroad back to India (and giving all Indians a sudden gift — what an empty promise!). The people who are best equipped to avoid the intended trap of demonetisation are precisely the ones who are seasoned dealers in black money — not the common people and small traders who are undergoing one more misery in addition to all the deprivations and indignities from which they suffer.”

Prof.Kausik Basu said thatDemonetization was ostensibly implemented to combat corruption, terrorism financing and inflation. But it was poorly designed, with scant attention paid to the laws of the market, and it is likely to fail. So far its effects have been disastrous for the middle- and lower-middle classes, as well as the poor. And the worst may be yet to come. India has a large amount of what is known as “black money,” meaning cash or any other form of wealth that has evaded taxation. According to a 2010 World Bank estimate, the most reliable available, the shadow economy in India makes up one-fifth of the country’s G.D.P. (A 2013 study by McKinsey, the consulting firm, puts the figure at more than one-quarter.)

Black money tends to exacerbate inequality because the biggest evasions occur at the top of the income spectrum. It also deprives the government of money to spend on infrastructure and public services like health care and education. According to the World Bank’s most recent estimate, from 2012, India’s tax-to-G.D.P. ratio is about 11 percent, compared with about 14 percent for Brazil, about 26 percent for South Africa and about 35 percent for Denmark. The government’s wish to tackle these problems is laudable, but demonetization is a ham-fisted move that will put only a temporary dent in corruption, if even that, and is likely to rock the entire economy. The government’s demonetization dragnet will no doubt catch some illicit cash. Some people will turn in their black money and pay a penalty; others will destroy part of their illegal stashes in order not to draw attention to their businesses. But the overall benefits will be small and fleeting.

One reason is that the bulk of black money in India isn’t money at all: It’s held in gold and silver, real estate and overseas bank accounts. Another is that even if demonetization can flush out the black money that is held in cash, with no improvement in catching and punishing tax evaders, people with ill-gotten gains will simply start saving in the new bills currently being issued. There also is no evidence that black money actually is more inflationary than white money; nor in theory should it be. Black money is just money held by people instead of the government. It’s an excessive money supply that tends to create inflation; whether that money is white or black makes little difference. Tackling corruption also goes beyond currency, cash or even banking. It requires changing institutions and mind-sets, and carefully crafting policies that acknowledge the complexity of economic and social life. The government could start by increasing penalties for tax evasion and amending India’s outdated anti-graft laws.

In a country like India, where the illegal economy is so intimately intertwined with the mainstream economy, one inept government intervention against shadow activities can do a lot of harm to the vast majority, who are just trying to make a legitimate living.

Rajan said , “ I am not quite sure if what you meant is demonetise the old notes and introduce new notes instead. In the past demonetisation has been thought off as a way of getting black money out of circulation. Because people then have to come and say "how do I have this ten crores in cash sitting in my safe" and they have to explain where they got the money from. It is often cited as a solution. Unfortunately, my sense is the clever find ways around it.
They find ways to divide up their hoard in to many smaller pieces. You do find that people who haven't thought of a way to convert black to white, throw it into the Hundi in some temples. I think there are ways around demonetization. It is not that easy to flush out the black money. Of course, a fair amount may be in the form of gold, therefore even harder to catch. I would focus more on the incentives to generate and retain black money. A lot of the incentives are on taxes.
My sense is the current tax rate in this country is for the most part reasonable. We have a reasonable tax regime, for example, the maximum tax rate on high-incomes is 33%, in the US it is already 39% plus State taxes, etc., it takes it to near 50. We are actually lower than many industrial countries. Given that, there is no reason why everybody who should pay taxes is not paying taxes. I would focus more on tracking data and better tax administration to get at where money is not being declared. I think it is very hard in this modern economy to hide your money that easily”.

Post-Demonitisation period

We have faced very short run effects on the following areas of the economy,name,[i]share market returns fell and there is shock in stock market,[ii]bank deposits rose abruptfly,[iii]adverse impact on industry especially on automobile,GDP,consumption and reality sector ,[iv]land price decreased,[v]housing price fell down,[vi]inflation rate came down

It is expected by the government that high credit in the economy may improve unemployment but it should be noted that NPA may increase if loans from banks are not repaid in time and high NPA will cause fall in banking profits.

If government fails to supply of adequate liquidity in banks and ATMs for the people then liquidity crisis may lead to banking crisis that may produce financial crisis too.

Lastly,adopting another currency or introducing a new currency does not solve the economic crises, unless it is followed by massive corrections in the macroeconomic fundamentals