Prime Minister Narendra Modi has announced demonetisation of high denomination currency keeping in view the manifesto of the party to fight corruption and respecting the sentiments of voters. Despite the pain which people are facing in the exercise, generally the scheme has been hailed by Indians across the spectrum. The sentiments are positive and encouraging.

First, some facts about the demonetised currencies. The note of ₹ 500 was introduced in October 1987-88 while notes of ₹1,000 were discontinued in January 1978 and reissued in November 2000. The history of ₹1,000 note is interesting. It was first introduced in 1938 under the British rule and then demonetised in January 1946. Once again it was introduced in 1954 and demonetised in 1978 to be re-introduced in 2000. The total currency in circulation as on end March 31, 2016 is ₹16,415 billion of which notes of ₹1,000 denomination account for 38.6 per cent (₹6,326 billion) and ₹500 account for 47.8 per cent (₹7,854 billion). The importance of ₹500 has been increasing over the years, from 4.1 per cent on March 31, 1990 to 47.2 per cent on March 31, 2016. Similarly, the share of ₹1,000 note has increased from 1.7 per cent in 2001 to 38 per cent in 2016. The total amount of ₹500 and ₹1,000 notes amount to ₹14,180 billion as compared with India’s national Income of ₹1,35,761 billion in 2015-16 or about 10.5 per cent of GDP. Assuming that the size of unaccounted economy in India, conservatively, is nearly 30 per cent of the official economy, amount of ₹4254 billion in high denomination notes could be due to unaccounted money.

Malaise of Corruption impacts Economic Growth The malaise of corruption which has been harming the country has various implications for the economy. Corruption undermines the government’s ability to deliver economic growth and adversely affects a number of variables like macro financial stability, investment, human capital formation and productivity. It can also lead to distrust of government policy which if becomes pervasive can lead to violence and conflict with social and economic implications.

Prevention of corruption needs strong policy deterrence which requires effective administration, and technology based data processing to generate actionable intelligence. In India, black money is estimated between 10 and 30 per cent of official national income. The Modi government, in the last two years, has initiated various measures to fight corruption like transparency in decision making, enhancing rule of law, deregulation and simplification of rules.

Objective Demonetisation of high currency notes has a two-fold objective – first, choking the funding channels of militancy and terrorism from across the border. In the last few years large number of counterfeit notes were regularly discovered in states infested with terror activities. Thus, demonetisation will certainly paralyse financing of terrorist activities. The other objective, to fight corruption, is rather complex and needs to be addressed persistently through different ways.

Implications of Demonetisation The economic implications of demonetisation are many and yield mixed results. First, it would inspire confidence of international community that India is serious about its commitment to fight corruption. This will enhance India’s ranking in ease of doing business as well as in various global indices of corruption.

It is rather difficult to predict the impact of demonetisation on the economy. The immediate pain in terms of non-availability of required currency notes if not corrected soon, may reflect in reduction of output in agriculture, which may spillover to industry and services. Similarly, in the long run, implications could be uncertain. On one hand, confidence in efficient management of the economy should lead to a positive effect while shock strike at unaccounted economy could lead to shrinkage in production, especially in the informal sector including micro, medium and small enterprises. The microfinance institutions, in the absence of high denomination notes, could suspend some of their operations for a short time.

If the efforts of the government result in unearthing a substantial amount of dormant money implying that stock of money would become a flow, then theoretically, prices would go up as more money would be chasing limited amount of goods. On the other hand, if there are liquidity constraints impacting production because of non-availability of required currency notes, then inflationary pressures will be subdued along with lower production. Similarly, though exchange rate is depreciating in the short run because of high demand of US dollars, the medium to long term trend would depend on growth and inflation.

As demonetisation was planned beforehand, the Government must have factored in repercussions like sluggishness in the stock and housing market, and in general, government’s tax revenue in quarters ending December and March. But if the Government is able to garner substantial amount of unaccounted money, it will add to revenue in the Budget. The issue of new notes, would enhance the seignorage of the Reserve Bank of India, leading to higher dividend for the Government, leading to higher fiscal expenditure.

On the basis of macroeconomic analysis, due to short-term liquidity constraint, consumption would not be impacted, nor would business investment which is largely based on overall climate and interest rates. Demonetisation will lead to lower conspicuous consumption and real estate activity. Thus, residential investment could suffer and impact 300 industries which provide inputs in housing sector. Therefore, India’s growth rate in short run could be a matter of concern unless Government uses the fiscal multiplier to boost growth.

The severity of demonetisation could result in enhancing fear of placing deposits in banks to avoid detection, and people may pursue other alternatives. Further, people may even be cautious in holding high denomination currency in their homes, which may get diverted to investing in gold, real estate and other activities. However, mistrust between the government and the private sector may need to be addressed so that currency is held by the public with confidence rather than with uncertainty and fear.

The expected introduction of Goods and Sales Tax (GST) in April 2017 would have led to better observation of accounting standards. Demonetisation would hasten the process of such accounting standards because of shift from currency to digital payments and banking.

Would demonetisation lead to popularising digital money? A number of factors need to be taken into consideration. India is a very diverse country in terms of languages and scripts. Also, the country has low level of literacy of about 70 per cent, with an English literacy of not more than 10 per cent of the population. Given the fact that all electronic devices have English numerals and all communication on digital banking is also in English, there is natural barrier to completely digitalise Indian economy during immediate period.

India continues to have 30 per cent of its population or nearly 40 crore people below the poverty line. These people could also be slow in embracing digital economy.

Ninety per cent of the Indian population operates in the informal sector. Illustratively, the transport sector including taxis, auto /cycle rickshaws, horse carriages and bullock carts work on cash payment as also most of local markets/shops/dhabas and similar business outlets, especially in rural areas. In addition, low volume of business in rural shops, shopping sheds, rural makeshift kiosks may not justify the cost of installing equipment to read and safely secure the data on plastic money.

Some Suggestions However, the recent demonetisation has only hit the stock of unaccounted wealth kept exclusively in form of currency. To curb regular accumulation of more unaccounted money, Government could institute a mechanism of incentivising tax compliance and punitive and demonstrative deterrents for those caught while generating black money. Extensive financial literacy on the harmful impact of unaccounted money – ranging from personal health to national loss — will help. This should become part of school and college curriculum. Finally, and most importantly, Government could consider transparency in political funding/election funding as in the USA and some other advanced countries.

It is a unique experiment in the world with no precedence. To understand the dimension of the problem consider an illustration where 86 per cent of blood in the body has to be changed while the patient is working normally and is not in ICU. Thus, in tirelessly undertaking this herculean task commercial bankers need to be applauded. The work is still incomplete and expected to last a few more weeks, given that ATM machines have yet to be calibrated. Therefore, with hindsight, to ease the pressure on branch and considering convenience to customer, commercial bankers can consider organising kiosks at secure places like schools/colleges/hospitals for exchange of limited quality of notes. Only customers with large requirements, need to go to the branch.

So the whole operation was kept secret as necessitated. But the last mile turned out to be rather difficult as serpentine queues outside every branch and every ATM of the country were proof of the fact that bank branches were not battle-ready.

India is the fastest growing economy of the world with a small Current Account Deficit, sufficient fiscal space, low inflation, and rising foreign exchange reserves. In fact, India with nearly 60 per cent of population below 35 years will be unchallenged for next half a century. Hence, despite pain, the country is unified in this rare opportunity, to cleanse the economy from cancer of corruption, while on its way to becoming a superpower.

The author is RBI Chair Professor, Indian Institute of Management, Bangalore

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