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Impact of demonetization


The demonetization of Rs 500 and Rs 1000 amounts to a significant monetary tightening especially for the informal sector and is likely to affect production and economic activity in this quarter. Rs 500 notes constitute the bulk of the currency used for transactions in the Indian economy. Along with Rs 1000 notes, it constitutes about 86 percent of the currency in circulation. The total currency in circulation as of October 28, 2016 was Rs 17.77 lakh crores. On November 9, 2016 currency in circulation suddenly declined to 14 percent of the currency of the previous day. The sudden announcement by the prime minister has a number of objectives. Among them are tackling counterfeit notes, curbing black money and restricting finance for subversive activities. While progress will be made by suddenly making the present high denomination currency illegal, we need many more steps before the desired objectives can be fully achieved.

One of the main objectives of replacing old currency notes by printing new notes is to tackle the problem of fake currency notes in circulation. In India, there is fear that counterfeit currency is being used for financing terror as well as other subversive activities. If security features of the present notes are weak and there is rampant counterfeiting, there is a need to replace these with new notes that have better security features. Usually, this is done gradually. So, for instance, the RBI could have started issuing new Rs 500 notes, allowed old notes to be exchanged for new ones and issued a deadline after which the old notes would not have been legal tender.
This is typically the strategy followed by most central banks, who are, in general, in a constant battle with counterfeiters. Curbing counterfeiting of internationally accepted currencies like the US dollar, which is used all over the world for legal and illegal activities is supposed to be a constant challenge.
In India, the problem of fake rupee notes has been noticed for many years. It has been difficult to estimate the size of the fake notes in circulation. It is not known whether the counterfeiting is done in India or across the border. Currency notes with better security features are certainly welcome, though it is not obvious that such a sudden move would make a big difference to this objective. It could have been done slowly with banks not giving out old notes until the last hour.
Some see this move as a way of pushing the country forward towards a cashless economy. There are two problems with this perspective. First, it is not that high denomination currency notes will go away. The existing notes will be replaced by new notes. Second, the cashless ecosystem is not ready to support a whole range of new users; this push is premature. As the queuing up for new bank notes indicates goods and services such as agricultural products, milk, vegetables, medicines, hospital bills, and a large number of other legitimate uses are transacted mainly using cash. 
Then is the objective of curbing black money. Black money is money that has not been declared as income to the income tax authorities. It is not necessarily obtained from crime or corruption. All black income is not held in cash. Some estimates suggest that about 6 percent of black income is held in cash in rupees. The rest may be in gold, property, benami bank accounts, foreign bank accounts etc. Similarly, all cash is not black income. Legitimate businesses deal with large amounts of cash. Petrol pumps, white goods dealers, textile merchants and jewellers often have large cash holdings by the end of the day with many consumers paying in cash. Farmers income is cash but as farm income is not required to pay income tax, it is not black money. Nor is the income of the mass of the Indian population, more than 95% whose income falls below the taxable limit.
Cash will either have to be exchanged by the holder at a bank himself or through someone. For some days, it will be disruptive for business. It would not be surprising if, in some time, a black market pops up to exchange old notes for new notes, thereby converting black money into white. This could be in the 50-day period in which the old notes can be exchanged with new ones. Reports suggest that this has already started happening. There would, of course, be a discount on the exchange.
But the ban will certainly hit those who are holding black money in cash. Corrupt bureaucrats, politicians and many more with piles of cash must be wondering how to handle the situation and how long to wait before they try to solve it. Since the present high denomination notes are going to be replaced by new notes, it is not that cash will no longer be used for corruption and storing black money — though it is likely that dollars, gold or diamonds could become more popular for such illegal purposes due to the fear of such a ban recurring.
However, while the ban may address the problem of the stock of black money in cash, the question is: Will it encourage people to disclose all income and start paying taxes on it? Or does that require simplification and rationalisation of the tax system? As long as agricultural income can be used as a route to avoid taxes and indirect tax rates have multiple rates and exemptions, the problem of tax evasion is unlikely to go away.
On the negative side, the disruption in transactions could hit the emerging growth of consumer demand. In 1978, India denotified the 1,000 rupee note, and nothing much happened. A black market sprang up, people who had these notes took a loss while selling off these notes to people who could claim these as legitimate income. At the time, those notes were 0.6 per cent of the cash in circulation. Things are more daunting this time as 85 per cent of the cash in circulation is in the old Rs 500 and Rs 1,000 notes.
A monetary economics perspective is useful. In India, there is one concept of money supply for the formal economy (the total money in all banks) and another concept of money supply for the informal economy (the cash in circulation). We will have an 85 per cent reduction in money supply for the informal economy for some days. Money is the means of transacting in the informal economy — payments will be held up and purchases will be postponed. Our main concern is about the large monetary tightening that has unexpectedly hit the informal sector. For perhaps 40% of the economy, money supply just went down by 85%. Even if a part of the currency was used for savings, the bulk of it was for transaction, as cash is not an attractive savings instrument, whether for legal or illegal businesses. Establishments might take credit from their employees by postponing wage payments. Many purchases would be postponed by establishments, employees and entrepreneurs. This is likely to generate a negative demand shock in the macroeconomy. All firms have operational leverage (promises to make payments for salaries, suppliers, interest, etc). On 10th November, many informal sector firms experienced a sharp decline in revenue while undergoing a continued low of expenses. As the days go by, many of these firms will experience corporate financial stress. Most of these firms are cutoff from the formal financial system and lack easy credit access. They will pull back on expenses. The informal sector and the formal sector trade with each other. Difficulties in 40% of the economy would have an adverse impact upon the remaining 60%.
There is a widespread sense that the decision of the government is bad news for bad people but for the rest we will be fine. This thinking may be too complacent. In the last few months, RBI, government, the newly constituted MPC and many observers have realized that demand in the Indian economy is weak and there is a need for monetary easing. 
In the decades before the policy rate was used for monetary policy, the main instrument of monetary policy used to be money supply. Now we have got a huge reduction in money supply. The timing of the monetary tightening is inconsistent with the stance of monetary easing. We expect that this sudden tightening will negatively impact production in the quarter Oct-Dec 2016.
The author is Professor, NIPFP. Click here for detailed profile.
The views expressed in the post are those of the author. No responsibility for them should be attributed to NIPFP.
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