On November 8th, as the Indians were glued to their TV sets to figure out which way the American election was unfolding, the Indian Prime Minister Narendra Modi appeared on Indian TV to announce what is now termed as “the big bang economic reform” to reportedly “demolish the citadel of corruption in the Indian economy”.
This most impactful portion of the address that took everyone by surprise was when the Prime Minister abruptly declared that 500 and 1000 Rupee notes, currently the highest denominations in circulation, would cease to be legal tender by the midnight hours of November 9, soon to be replaced by new 500 and 2000 Rupee notes in the future.
Modi also announced that those holding cash in the earlier currency could deposit those into the banking system by December 30, 2016 without any limitations. However, cash deposits of more than 250,000 will be taxed and a penalty of 200% can be levied in case of income mismatch.
In coming times, the demonetization drive will be seen as a massive shock to both the economy as well as society. If implemented well, it will send out a strong message regarding India’s fight against black money and may reiterate the country’s position on corruption.
Modi’s address evoked many different emotions among different constituents ranging from happiness, relief, dismay, shock , concern to widespread confusion.
The Indian economy which is heavily dependent on cash went on edge with long queues of people waiting in front of banks to exchange their old notes. Chaos ensued across banking districts with long queues and cash shortages ending up into brawls. Opposition parties came down heavily with strong criticisms of the government’s move.
Interestingly, despite all the troubles there is considerable appreciation of the move among a large swath of the Indians, who are OK with the government initiative so long as it can genuinely fulfill its promise of curbing corruption and stemming the circulation of black money.
The Indian economy is predominantly cash-based — more so than most other countries in the world. India’s cash-to-deposit ratio is much higher than that of USA , Europe, for example. The large cash-to-deposit ratio could be attributed to hoarding of undisclosed income. India’s outsized informal economy is also a major factor for the significant role cash plays in everyday life in India. Many businesses in India operate only on cash without any accountability or transparency. This money does not ever enter the tax system. It is reported that up to 66% of the GDP of India is in cash.
Since there are lots of unaccounted cash in the system, revenues from taxes are not adequate and this results in the government having not too many option but to raise taxes. A cash-based economy is also the cause of corruption where the system is run by money that is unaccountable. Demonetization may not necessarily weed out all corruption, but will certainly make it possible to recover the unaccounted cash in circulation. The real estate sector will be among the earliest to feel this impact, as the inflated property prices are a result of circulation of this unaccounted money available in the system. Prior to this move, properties were being sold at a 90:10 ratio of black and white money respectively. This trend may get reversed now.
Demonetization is not a new phenomenon; it has been done before in India and in other parts of the world. For years, economists like Richard Thaler and Ken Rogoff have argued in favour of an economy that operates on less cash leading to a fairer and safer system.
A demonetization drive would be incomprehensible if families with low-incomes had remained unbanked.
In hindsight, the demonetization announcement has been timed appropriately, with the banking inclusion scheme of the Prime Minister nearly complete granting the common man access to banking. A demonetization drive would be incomprehensible if families with low-incomes had remained unbanked. The honest person therefore, no longer needs to keep money in mattresses. This initiative by the Prime Minister was followed by the disclosure of income scheme giving people an opportunity to come forward and declare wealth amassed by various means.
The coming months will not be easy and need to be looked upon as initial troubles of an economy cleansing itself. A critical need of other payment mechanisms like electronic transfers, debit cards, and mobile payment avenues will self-emerge. Financial institutions, payment gateways, and telecom platforms will step up to fill any gap that will remain.
The government has already introduced new Rs 2,000 bills to enable legitimate transactions in cash and have therefore designed them with increased security measures.
While demonetization may not put an end to all forms of corruption, it will definitely reduce informal money networks, which may eventually lead to less wrong doing and criminal activity.
In coming times, the demonetization drive may act as a shock to both the economy as well as the society. If implemented well, nonetheless, it will send out a strong message regarding India’s fight against black money and the country’s position against corruption. In addition, it will give a fillip to the program of the government geared towards improving financial inclusion, encouraging more households adopt a payment and banking system that is efficient. In shorter term, Indians will see larger deposits in banks, corrections in prices, and improved collection of taxes—all welcome news for India.