In India’s own modern economic history, there were two previous attempts made to demonetise existing currency units. The first was when Rs 5,000, Rs 10,000, Rs 1,000 notes were taken out of circulation in 1946. The second was in 1978, when Moraji Desai-led Janata Party coalition used the High Denomination Bank Notes Act to declare these three denominations as illegal. While I G Patel, then RBI governor in 1978, criticised the move by Desai’s demonetisation attempt, this time, RBI Governor Urjit Patel has backed Modi’s move acknowledging the “growing menace of fake Indian currency notes”.
Recently, economist Ajit Ranade argued how large denomination notes are highly likely to be used for illegal activities and not so much as a medium of ordinary transaction. One reason for this is because currency notes with high denominations are rarely used in a wider use on a day to day basis and ultimately serve the best interests of money launders, real estate players or other tax evaders.
Having said that, the share of Rs 1,000 notes in the stock of currency circulation is as high as 39% (in 2014-15) and Rs 500 notes accounting for 45% of the currency stock. Combined, the share of Rs 500 and Rs 1,000 notes account for over 85% of all currency notes in current circulation.
For the RBI, this may seem a bit strange, as the velocity (frequency of circulation of money) is usually the highest for currency units with lower denomination while the demand in the Indian context has been highest for units with higher denomination (Rs 500, Rs 1,000), which explains how most illegal money circulation is happening using these two higher denominations itself.
The administrative challenges ahead: As these notes go out of money stock (for the time period), the demand for currency notes with smaller denominations (Rs 10, Rs 20, Rs 50, Rs 100) will scale up severely. As noted by a recent study, “the cost of printing a Rs 10 note is Rs 0.96 or 9.6% of face value, while the cost of printing a Rs 1,000 note is only 0.32% (or Rs 3.17) of the face value”. The impact of demonetisation thus, is likely to affect RBI’s own cost of printing new denominations.
For those who pay taxes diligently, demonetisation is likely to be an administrative nightmare. Especially so for banks which are already finding it difficult to cope up with the pressure of handling long queues as people come to exchange older currency notes for newer ones.
To what extent the demonetisation currency reform is likely to affect the growing level of corruption (through the creation and circulation of illegal wealth)? On deconstructing the basic essence of corruption as a crime of calculation, in a simple yet powerful formula, corruption equals monopoly plus discretion, minus accountability (C=M+D-A). And wherever these conditions shall continue to exist (whether in the public sector or private sector), corruption, including the circulation of illegal wealth shall prevail.
The institutional solution to corruption lies in going beyond the demonetisation reform and in promoting reforms with respect to demonopolisation across sectors; eliminating human discretion by ensuring the filing of e-returns for income tax, conducting automatic assessments and sending tax refunds to assessee bank accounts, and ensuring financial accountability through effective income declaration methods.
India, as one of the most cash-intensive economies with a cash-to-GDP ratio of 12%, which is almost four times (as per a report) higher to other emerging economies, has still a largely unbanked base. For the widely spread rural India, a radical switch to electronic payment systems or plastic money (as a result of demonetisation) seems unrealistic and will require persistent efforts in ensuring parity for enabling disclosure of unaccounted wealth.
Having said that, the advantage of such a currency reform lies in immediately dealing with the problem with fund mobilisation (using cash to fund polls) attached with political parties (in times of election season) where more cash is distributed as a medium of exchange is likely to be brought under check for the time. The move may thus have a significant impact on the ensuing Uttar Pradesh elections (due in January-February, 2017) where the frequency and density of cash transactions is far more than other states (owing to its large unbanked, informal market base).
One of the other likely advantages of the Nov 8 step can be in respect of increasing the level of bank deposits (with people in thousands coming to declare black money held with them in the form of currency notes of Rs 500 and Rs 1,000). The process may allow banks to significantly boost their household deposits and capital requirements, allowing them with a higher capital base to further increase lending and credit needs.
In any case, the demonetisation currency reform move can be summed up as a welcome bold move, one that will require consistent efforts on part of both the government and the central bank to ensure its efficacy in combating the rise of black money and corruption levels.