Demonetization in India: What is the Risk Reward Ratio?

The government believes that demonetization will help erode “black money”, or untaxed wealth, currently estimated at $420 billion or 20 percent of GDP, from the economy, with Modi contending that demonetization is just the “beginning” of his fight against corruption.

Written by Devyani Nijhawan

Imagine one day you wake up and discover that the money in your wallet holds as much value as the paper currency used in a game of Monopoly – that’s exactly what happened to India on November 8 this year when Prime Minister Narendra Modi announced the demonetization of 500 (US $7.50) and 1000 (US $15) rupee notes, the largest denomination Indian rupee bills. Accounting for a whopping 86 percent of India’s total cash in circulation, notes worth $224 billion will, in the PM’s words, be “worthless pieces of paper” starting midnight of November 8. Instead, the Reserve Bank of India (RBI), India’s central bank, has issued new 500 rupee notes along with a higher denomination 2000 (US $30) rupee note.

The rationale behind this unexpected policy decision is to curtail unaccounted money and eliminate counterfeit currency from the economy. Backed by the International Monetary Fund, this currency policy apparently promises positive long-term results but suffers from implementation issues threatening to derail the economy.

The immediate aftermath of the announcement was a liquidity crunch in the country. Ambit Capital, a Mumbai-based equity research firm, reported that 90 percent of India’s transactions in 2012 were cash-based. So, groups that heavily rely on cash, including street vendors, small business owners, daily wage laborers, and farmers, felt the real impact of the announcement. Limits on daily exchange and withdrawal have further exacerbated people’s hardships. Moreover, many rural Indian households don’t have any kind of identification, let alone access to a bank account.

The systems in place to facilitate the exchange of currency notes have fallen far short of expectations. People have had to leave work and stand in long lines outside banks for hours to exchange old bills (imagine Black Friday for exchanging currency notes). Several complaints have arisen from citizens, including accusing banks falling short on cash and on smaller denomination notes for exchange. Moreover, two weeks after the announcement, people were still unable to access ATMs. The Indian Finance Minister Arun Jaitley said that the country’s 200,000 ATM machines could not be recalibrated ahead of time to “maintain secrecy” of the operation, explaining that secrecy was crucial to refrain from tipping off cash hoarders and counterfeit currency users, the main targets of this policy decision. Acknowledging people’s difficulties, the government relaxed restrictions for India’s vulnerable groups, including farmers and small traders. And Modi, using emotional appeal, has been reiterating that the move is geared to aid India’s poor; he is pleading everyone “to make short-term sacrifices in the interest of long-term gains.”

But the big question remains whether demonetization will attain the goals it was set out to achieve? The answer is complex, and experts remain divided on the issue.

The government believes that demonetization will help erode “black money”, or untaxed wealth, currently estimated at $420 billion or 20 percent of GDP, from the economy, with Modi contending that demonetization is just the “beginning” of his fight against corruption. He cited the formation of a Special Investigation Team (SIT) on black money and mandating the disclosure of foreign bank accounts, among other efforts to tackle corruption. But pundits seem to be split into two camps. Mauro F. Guillen, a professor at the Wharton School, favors the move, saying “in the short term, it could stifle some businesses that are legal and clean, if they use cash payments” but remains optimistic saying that “everyone will eventually adjust.” On the other hand, Kaushik Basu, former World Bank Chief Economist, says that “demonetization is not good economics”, adding that “its economics is complex and the collateral damage is likely to far outstrip the benefits.” Moreover, Kunal Kumar Kundu, VP and India economist at Societe Generale, argues that cash makes up only 5 to 6 percent of India’s parallel black economy, as evidenced by tax raids, adding that “the equipped can find ways around demonetization by converting their existing cash to other assets through middle men.”

Moreover, issuance of the 2000-rupee note remains perplexing. The main premise of demonetization is to deter people from hoarding cash. Wharton professor Mauro Guillen explains that “large-value currency is an important source of problems, such as corruption, terrorism, black money, and counterfeit currency.” He provides the example of the European Union that is permanently abolishing the 500 euro note, with its contribution to crime in recent years. Then why is India’s central bank printing an even bigger denomination bill? Experts claim that the 2000 rupee note is the central bank’s response to rising inflation in the economy. But, largely, no clear stance exists on this decision.

Furthermore, fake Indian currency notes (FICN) are increasingly being deployed by terrorist organizations, smugglers, and traffickers to finance their operations. Corroborating the risk, Financial Action Task Force, an intergovernmental policy-making body, reported in 2013 that India came in third with 575,747 FICN in terms of number of notes reported as counterfeit by different countries. Demonetization claims to flush out this counterfeit currency that poses a serious threat to national security. While the government claims that the new notes are difficult to counterfeit with their additional security features, concerns still prevail. Fake 2000 rupee notes have already been discovered in several parts of the country.

Financial inclusion and digitization have been pitched as added benefits of demonetization. The government’s assumption is that the 50-day deposit window for the old currency notes will compel the ‘unbanked’ to open bank accounts. Data reveals that 65 percent of India’s adult population is financially included, with literate individuals accounting for 71 percent of this number. Skeptics argue that the government has held its expectations too high, magically expecting the country’s rural poor to tackle the system with limited access to banks. Additionally, Modi is pushing for a cashless economy, urging the country’s youth or, the “Whatsapp generation”, to adopt e-banking for their daily transactions. To facilitate this transition, all online transaction fees have been waived until December 31st. Modi is trying to inspire the younger generation by putting the onus of the country’s development on them.

As far as the macroeconomics are concerned, the verdict is uncertain. Overall, the Indian economy will experience a significant disruption in the short-run. Demand for discretionary goods and services will shrink by a sizeable amount. Real estate, which is largely funded by black money, will be hit hardest until a price correction takes place, explains KV Kamath, chief of the New Development Bank of BRICS countries. Economists predict that more money in banks would cause a drop in interest rates and inflation. Manmohan Singh, India’s former PM and a highly revered economist, expects demonetization to cut 2 percent from India’s GDP. Meanwhile, the government remains optimistic about the country delivering growth at a much faster pace after the cleanse is complete in two to three quarters.

Systemic corruption today is woven into the fabric of Indian society. Many people are frustrated and are willing to give the PM’s audacious decision a chance. It’s a gamble, to say the least, but there is indeed a risk-return tradeoff. Whether demonetization will hit a grand slam or result in an unmitigated disaster, no one knows yet. Until the verdict is out, let patience be thy friend.