India’s ban of issued Rs. 500 and Rs. 1000 Bank Notes: Much Awaited “Acche Din”?

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Brexit, Mr. Donald Trump becoming President Trump and the Indian ban of its highest monetary denominations (Rs. 500 and 1000); 2016 has presented us with unexpected scenarios. However, I will be dwelling on the Indian subcontinent’s monetary ban.

Revisiting Narendra Modi’s campaigning phrase, Acche Din, was to reckon elimination of poverty and uplifting the social status of society members. With almost half of his tenure over, Modi was reaching a point where his promises were returning to plague him. Narendra Modi was elected in hope of being the change that people wanted after a long era of Congress ruling. Though the government has skilful control over social and conventional media, there’s been public discourse surrounding the government’s incapability to satisfy the common people’s needs. Therefore, it’s safe to say, so far, he hasn’t been standing true to the expectations — until now. On November 8th, 2016, Prime Minister Narendra Modi publicly announced the ban and removal of Rs. 500 and Rs. 1000 denominations from the nation’s capital flow. In the world’s seventh largest economy, where much of monetary transactions are in cash and approximately 90% of money is possessed in Rs. 500 and Rs. 1000 denominations, Modi has taken a bold step.

As everyone celebrates the sudden withdrawal of Rs. 500 and Rs. 1000 denominations as a tool to combat corruption, here is my prima facie skepticism — will the third time work its charm? and what are the unforeseeable repercussions to this decision?

When I say the ‘third’ time, I mean that our current Prime Minister’s move isn’t unprecedented, and history seconds that selected denominations have been pulled out before with the introduction of new ones. Let’s roll back in time as I enlighten you with such scenarios.

In January 1946, the withdrawal of Rs. 1000, 5000 and 10000 denominations was witnessed for the first time. However, with no clear motive, they were reinstated in 1954. The ‘70s saw the government tax committee, Wanchoo committee, spark up with the same idea. However, with the inside information becoming public before it could be implemented, the cunning hoarders acted fast and got rid of the denominations. This couldn’t allow the government to pin them down and fight corruption. In 1977, the Janata Party came into power through a coalition government, with its face as Morarji Desai. His courageous promises to eliminate black money and curb corruption led him to demonetise Rs. 1000, 5000 and 10000 bills for the second time in history. And now, Modi is back with the same bang! The difference being, Modi has current RBI Governor Urijit Patel’s ultimate support; whereas, Desai’s idea was trashed by then RBI Governor I.G Patel as trying to cripple the predecessor government and its employees rather than eliminate black money.

Though Modi had concealed the idea for six months, quarantined the three people he worked with to implement the ban, and ensured that the big fishes get no time to secure their black money, there may be other benefits and repercussions. Let’s look at the positives first.

‘Aapka Paisa aapka rahega’/‘Your money will be yours’ — Modi. Standing true to the statement, Modi requires the people to deposit their old denominations to the nearest government banks and post offices by December 30, 2016. This would lead to two things: increase in the bank cash deposits and an increase in the opening of new bank accounts (especially in the rural sectors). These actions would lead to a boost in bank deposit growth and government’s financial inclusion trust, hence moderating the currency. Having closed the former voluntary disclosure window for black money, it’s been reported that government would keep a watch on those who deposit over Rs. 2 lakh (200,000) in cash and may eventually tax or fine them if records aren’t produced for such possession. Clearly, this would lead to an increase in net tax, further leading to a higher tax collection and a much better tax to GDP ratio. It may not sound good at the moment, but in the long run, as black money is brought under authorised channels, the government’s tax revenue collections will soar, and eventually the government might reduce the tax rates. This can be interpreted as playing along with the recent talked-about tax regime of implementation of GST. “Demonetisation would increase the tax net and along with GST result in reduction of black money generation. Along with GST, demonetisation will lead to a higher tax/GDP ratio”, says CLSA.

Contrary to popular notions regarding its precision, this policy seems to be a fairly blunt instrument with the potential for more widespread consequences. For example, a simple transaction associated with the exchange of these tenders for lower banknotes may be considerable in a macroeconomic context. Such high value transactions (especially gold and land) would result in lower inflation, tempting the central banks to lower the interest rates. CLSA’s points out that banks would benefit with higher CASA (current account savings account) growth as a part of the $190 billion cash pile that gets deposited with them. Higher deposit growth and continuing weak credit growth would create opportunities for lending rate cuts and investment activities to pick-up. Thus, the bigger impact to be seen on the interest rates is the liquidity that the banks will be flushed with. Speaking about liquidity: movement of supplied products and capital will be hit. Quoting Merrill Lynch, “Wholesale channel forms over 40% of the sales for the Indian consumer firms. This channel works mainly on cash transactions and will likely witness liquidity constraints in the near term. This could disrupt the supply chain and impact growth in the December quarter”. It further goes on to say, “consumer firms typically provide tight credit terms (<7 days) to the distributors, who in turn provide credit to the wholesalers/ outlets on their own accounts. Due to overall tightening of the cash-liquidity in the supply chain, consumer firms may be forced to offer easier credit terms to the distributors in the near term. As a result we expect an increase in their receivables in the December quarter.” So in this case, is low inflation a good idea? Maybe not.

As we will move further with the policy, it will be noticed that the money lying idle will be injected in the economy, thus increasing yield and liquid assets. The money may also move to other investment tools such as gold, land, precious metals or plain cash again. Such equities would certainly reflect panic in the main economy but might be beneficial in the near future. But as the saying goes, every coin has two sides; this policy might actually lead to higher inflation rates. Governments often print large denominations, in response to high inflation. While paved with great intentions, such measures tend to reinforce existing inflationary pressures to varying degrees. That said, the CPI trajectory in India has remained downward for a few years now — so long term ramifications of the upcoming Rs. 2000 banknotes are to be seen. These will show upliftment in purchasing power of the consumer, which currently does not exist. Thus, it may derange the aggregate demand and aggregate supply equilibrium, eventually disrupting the economy. I acknowledge the reasoning behind forcefully channelling illegal money through regulated financial institutions in order to reduce the overall size of our underground economy. However, the prompt injection of capital into nation’s monetary circulation could lead to further increases in price levels. Moreover, the policy does little to change the mix of fundamental incentives that drive corruption, in and of itself. It appears to be a temporary fix to a much more pervasive problem.

Considering all of this, how many of positive boosts or negative blows would the economy have, only time will tell. But right now, everyone hails Prime Minister Narendra Modi; for showing us that he is pretty capable of the revolutionary decisions that people hoped he would take.

Written By:

Pranjalya Shukla

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One thought on “India’s ban of issued Rs. 500 and Rs. 1000 Bank Notes: Much Awaited “Acche Din”?”

  1. Naresh Pandey says:

    Nice view point Pranjalya 🙂

    all the best for future…:)

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