Demonetisation – a sovereign’s ultimate weapon

Currency notes and coins being the hallmark of any sovereign, any decision to withdraw the legal tender status of currency that is in circulation creates a sense of confusion and some despair. The monopoly rights of the sovereign to issue currency notes and coins are asserted in reverse in demonetisation episodes for achieving economic and political goals that seem difficult with normal policy measures. Its economic costs and benefits are hard to assess ex ante. More importantly, only a few among the population have a clear idea about how demonetisation could deliver the intended outcomes. Even under the best of circumstances, it's a hard sell for any government. 

The demonetisation announced in the evening prime time of November 8 is by all means one of the rare, bold economic policy decisions witnessed in the history of independent India. It is clear that that a good bit of planning and preparation involving the ministry of finance and RBI were completed beforehand. That this was done in absolute secrecy is no small feat. Although the authorities have identified nullification of black money hoarded in cash, tackling of counterfeiting Indian currency notes, and curbing of terror financing with fake currency notes as the three objectives of this round of demonetisation, quite a few commentators and analysts have opined that this will engender a marked fall in the use of cash transactions in India and thus pave the way for the transition to a 'cashless' economy.

To be sure, this measure will cause some hardship to people for the initial few weeks. And it is quite likely that the section of the population that live outside the banking system will be affected the most. Some fall in demand, particularly in all retail sectors is possible. However, it seems that the RBI has planned reasonably well to use its own offices/branches as well as about 134,000 branches of banks in the country to collect the demonetised notes and to supply new currency notes, including the new series of ₹500 and ₹2000 notes to minimise any disruption in the economic and social lives of people. Currency management operations of the RBI is one of its less glamorous functions that do not attract public attention except in times such as this. However, the RBI has the institutional capability to mobilise its resources, including experienced and skilled manpower to manage the occasion well.          

Comparison with the last demonetisation done by Morarji Desai government in 1978, though natural and somewhat compelling is not realistic, both in terms of their economic impact and the scales of the logistics involved.  Demonetisation high denomination notes – ₹1000, ₹5000 and ₹10000, also known as 'registered notes' in 1978, was a tame and a largely inconsequential affair. These three denominations together accounted for less than 10% of the value of the notes in circulation then. Very few would ever get to see a high denomination note in their lifetime then. The exercise redeemed close to 95% of the value of these notes in circulation, thereby generating negligible fiscal gain. The last date for the tendering of demonetised notes was extended by RBI which caused some controversy.

India is a cash-dependent economy.  Its cash to GDP ratio at 11% is much higher than most economies. Close to 98% of all consumer payments are made in cash. Financial technology companies in the payment services sector are upbeat that demonetisation will also mean a big digital push for India. Some of them have even seen a spurt in business in the wake of the announcement of demonetisation. Seen against the setting up of the Unified Payment Interface (UPI) in August this year and reported plans of the government to prohibit cash transactions involving ₹500,000 or more, there are reasons to be hopeful that India will leapfrog to a much lower dependency on cash over the next five years.

The demonetisation will, therefore, be a success if the fiscal gain is at least 25% of the value of ₹500 and ₹1000 notes in circulation, i.e., ₹3,545 billion, equivalent to about US$ 53 billion.

The main yardstick to evaluate the success of the demonetisation will be the fiscal gain accruing to the RBI and, hence, to the government, as a result. As per the latest RBI data (end-March, 2016), the ₹ 500 and ₹ 1000 notes together constitute, in value terms, 86.4% of the total notes in circulation. Their aggregate value is ₹14,180 billion. Over the last few years, the annual growth rates of the circulation of notes of these two denominations have largely tracked the growth rate of nominal GDP, indicating no sudden spurt in their demand.

The size of the black economy in India is estimated to be in 20-25% range. It is safe to assume that the structure of the black economy, including that of its 'cash component' has been fairly stable over the years. This leads another safe assumption that the proportion of black cash in the aggregate currency in circulation is also around 25%.  In fact, it should be higher than 25%, given the higher preference for cash in the case of tax evaders vis-a-vis others.

The demonetisation will, therefore, be a success if the fiscal gain is at least 25% of the value of ₹500 and ₹1000 notes in circulation, i.e., ₹3,545 billion, equivalent to about US$ 53 billion. The fiscal gain is sum of the value of the ₹500 and ₹1000 notes that will not be tendered for exchange or for credit to bank accounts plus the penalty that the tax-collectors will levy on those with mismatch between the notes deposited and their respective declared incomes.

Demonetisation of the huge scale that is currently under way in India is like wielding a sledgehammer at an enemy that has long evaded subjugation because of its sheer heft and some benign negligence on the part of those whose duty was to confront it head on.  It will be interesting to see how the government deals with the rising cacophony of opposition to this move. The denouement will indicate how the rest of the term of the present government will be like.    

(The writer is a former central banker and consultant to the IMF)