IPCS Debate

Demonetisation: An Exercise in Instability

14 Nov, 2016    ·   5179

Roshan Iyer argues against the recent demonetisation of banknotes of INR 500 and INR 1,000 by the Indian government

On 08 November 2016, the Indian government announced the demonetisation of INR 500 and INR 1000 banknotes with aim to curb the circulation of black money. This is the equivalent of using a wrench to hammer a nail. This move in isolation will in fact disrupt the informal cash-dependent sector (which constitutes a large section of the Indian economy) rather than the black money pool. A deeper analysis reveals that the instability caused by this announcement could have a devastating effect on the country’s small businesses, the commodities market, and the informal labour sector.

Demonetisations in the Past
In 1978, India demonetised banknotes of INR 1000, INR 5000 and INR 10,000. The move did little to stop the circulation and use of 'black money' and the then-RBI director IG Patel noted the highly political nature of the move.

Today, institutional studies on black money estimate the value of money in offshore accounts and foreign tax havens at between USD 300-USD 500 billion. Demonetisation does not in any way address this – which is why a similar move in 2014 on INR 500 and INR 1000 banknotes printed before 2005 did just as much as the 1978 demonetisation to curb the circulation of black money.

Likely Effects
The current round of demonetisation will be devastating to India’s Small and Medium Enterprises whose operations will be completely disrupted because they almost exclusively run on cash. The sudden announcement of the measure along with the national closure of banks and ATMs and the imposition of withdrawal limits of INR 20,000 per week is likely to see day-to-day business disrupted for these enterprises. Although digital transactions have not been limited, almost all these businesses transact in cash and not digitally.

The poor, especially the rural poor whose earnings and savings are almost exclusively in cash, will be hit hard. As they are hired on an informal basis and paid daily, they will face the most difficulty due to demonetisation and the withdrawal limits. Endless queues at banks and the weaknesses in India's financial administration systems will also result in lost wages for them and reduced productivity for labour-light small businesses.

Expect a shock to the market and instability across sectors. Gold and jewellery are likely to play a role of wealth sinks in the coming period. Individuals might have more confidence in these commodities and those with medium amounts of unaccounted liquid currency may simply buy up gold and jewellery. For a country whose gold demand is large enough to play an active role in its current account deficit, this will only serve to widen the gap. 

A Poor Move Overall
Moreover, the current demonetisation exercise was not implemented well. The lack of financial literacy along with the instability caused will ensure that it is the poorer section of the population that is likely to be most affected. Flaws exist in the current demonetisation exercise even in terms of the move's intended purpose as a tool to fight terror financing. Irrespective of whether terror outfits are funded by legitimate or counterfeit currency, demonetisation might temporarily disrupt the finances of these groups as cash-in-hand becomes unusable, but will not provide long-term solutions against foreign funding for terror operations in the country.

The move also fails to combat the circulation of counterfeit currency as no matter what high-tech new-fangled note the government decides to release, till date, there has never been a single "un-counterfeitable" currency; counterfeiting technology always catches up over time. For example, the USD 100 bill is simultaneously the most difficult note to counterfeit as well as the more counterfeited note in the world.
Furthermore, the strength of India's financial institutions will be put to test as to whether the economy can handle this period of instability. The task of switching out the entire country’s currency relies heavily on the strength of the government’s administration. Printing, replacing and disseminating 86 per cent of a country's currency is no small task. If procedures become tied up in red tape and bureaucracy, larger legitimate businesses will also be affected. Even contingency measures to keep railways, hospitals and petrol pumps afloat with notes have failed to keep up with the demand for notes. Furthermore according to the official announcement, post-deadline currency conversion procedures will require the applicant to submit so far unspecified “necessary” documents, which might point to an ‘Inspector’ Raj in its infancy.

India's 'black money' has always been a tough nut to crack. The definition itself is widely disputed and there is no final consensus on what exactly constitutes black money. Considering the nature of most (widely accepted) black money, this is a single faceted move; and instead, a more holistic approach to the black money problem is needed. 
Greater efforts to plug tax loopholes and negotiating stronger multilateral treaties on a global stage along with a range of international investigative measures into the sources might have been a better move to target the bulk of the black and counterfeit money. India might even be able to play a leading role in bringing tighter financial and tax laws to fight not only unaccounted income, but money laundering and tax evasion on an international level.