Economy

India’s Currency Must Be Held By the Public With Confidence, Not Uncertainty and Fear

While the army was able to conduct surgical strikes across the border and undertake relief operations during the Chennai floods, India’s bankers have been unable to rise to the battle cry in the aftermath of demonetisation.

ATM queue at Sundergarh in Orissa. Credit: Shome Basu

ATM queue at Sundergarh in Orissa. Credit: Shome Basu

Prime Minister Narendra Modi announced the demonetisation of high denomination currency keeping in view the manifesto of the BJP to fight corruption and respect the sentiments of voters.

First, some facts about the demonetised currencies. The Rs 500 note was introduced in October 1987-88 while the Rs 1000 notes were discontinued in January 1978 and reissued in November 2000. The history of the Rs 1000 note is interesting. It was first introduced in 1938 under the British rule and then demonetised in January 1946. It was once again introduced in 1954 and demonetised in 1978 only to be re-introduced in 2000.

The total currency in circulation as of March 31, 2016, was Rs 16,415 billion, of which notes of Rs 1000 denomination accounted for 38.6% (Rs 6,326 billion) and Rs 500 account for 47.8% (Rs 7,854 billion). The importance of Rs 500 has been increasing over the years, from 4.1% on March 31, 1990, to 47.2% on March 31, 2016. Similarly, the share of Rs 1000 note has increased from 1.7% in 2001 to 38% in 2016.

The Rs 500 note was introduced in October 1987-88 while the Rs 1000 notes were discontinued in January 1978 and reissued in November 2000. The history of the Rs 1000 note is interesting. It was first introduced in 1938 under the British rule and then demonetised in January 1946. It was once again introduced in 1954 and demonetised in 1978 only to be re-introduced in 2000. The total currency in circulation as of March 31, 2016, was Rs 16,415 billion, of which notes of Rs 1000 denomination accounted for 38.6% (Rs 6,326 billion) and Rs 500 accounted for 47.8% (Rs 7,854 billion). The importance of Rs 500 has been increasing over the years, from 4.1% on March 31, 1990, to 47.2% on March 31, 2016. Similarly, the share of Rs 1000 note has increased from 1.7% in 2001 to 38% in 2016.

Malaise of corruption 

The malaise of rampant 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 the distrust of government policy which if it becomes pervasive can lead to violence and conflict with social and economic implications.

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

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, a large number of counterfeit notes were regularly discovered in states infested with terror activities. Thus, demonetisation would certainly paralyse the financing channel 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 the confidence of the international community that India is serious about its commitment to fight corruption. It would also enhance India’s ranking in ease of doing business and in various global indices of corruption.

It is rather difficult to predict the impact of demonetisation on the economy. If the immediate pain in terms of non-availability of required currency notes is not corrected soon, it may reflect in the reduction of output in agriculture due to its timing being close to sowing season, which in turn may spill over to industry and services. Similarly, in the long run, there is an uncertainty about its implications.

On the one hand, confidence in the efficient management of the economy should lead to positive effect, while the strike on the unaccounted economy could lead to shrinkage in production, especially in the informal sector including micro, medium and small enterprises.

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 production is impacted due to liquidity constraints because of the non-availability of required currency notes, then inflationary pressures would be subdued along with lower production. Similarly, though the exchange rate is depreciating in the short run because of a high demand of the US dollars, the medium to long term trend would depend on growth and inflation.

As the demonetisation was planned beforehand, the government must have factored in repercussions like sluggishness in 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 a substantial amount of unaccounted money, it would add to revenue in the budget. The issue of new notes would enhance the seigniorage of the Reserve Bank of India, leading to a possible higher dividend for the government.

The severity of demonetisation could result in enhancing the 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 goods and services tax, which is expected to be introduced in April 2017, would have led to better observation of accounting standards. Demonetisation would hasten the process of such accounting standards because of the shift from currency to digital payments and banking.

Digital revolution: yea or nay?

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 a low level of literacy of about 70% and English literacy of not more than 10%. Given the fact that all electronic devices have English numerals and all communication on digital banking is also in English, there exists a natural barrier to completely digitalising the Indian economy during the immediate period.

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

Ninety percent of the Indian population operates in the informal sector. Illustratively, the transport sector including taxis, auto/cycle rickshaws, horse carriages and bullock carts all operate on cash payment just like most of the local markets/shops/dhabas and similar business outlets, especially in rural areas. Additionally, the 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.

Future roadmap

The recent demonetisation has, however, only hit the stock of unaccounted wealth kept exclusively in form of currency. To curb regular accumulation of more unaccounted money, the government could institute a mechanism of incentivising tax compliance and punitive and demonstrative deterrent for those caught while generating black money. It could also provide extensive financial literacy on the harmful impacts of unaccounted money – ranging from personal health to national loss. This should become part of school and college curriculum. Finally, and most importantly, the government could consider transparency in political funding/election funding as is the case in the US and some other developed countries.

It is a unique experiment in the world with no precedence. To understand the dimension of the problem, consider an illustration where 86% of blood in the body has to be changed while the patient is working normally and is not in the ICU. Thus, in tirelessly undertaking this herculean task commercial bankers need to be applauded. The work is still incomplete and is expected to last a few more weeks given that the ATM machines are yet to be calibrated. Therefore, to ease the pressure on bank branches and the inconvenience to customers, commercial bankers can consider organising kiosks at secure places like schools/colleges/hospitals for the exchange of a limited quantity of notes. Only customers with large requirements would then 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. While the Indian army was sufficiently trained to do highly advanced surgical operation across the border and was able to undertake relief operations during Chennai floods, India’s bankers, though hard working and dedicated, were not able to rise to the battle cry. A similar thing was noticed earlier when the increase in the number of Jan Dhan accounts was accompanied by an increase in NPAs, reflecting a lack of monitoring and diversion of attention from loan accounts. A similar rise in NPAs can be anticipated and to address this issue, the government can duly compensate commercial banks for deploying resources and manpower for the success of demonetisation.

Charan Singh is a  professor at IIM Bangalore.

  • Mandy S

    Thank you for a well-balanced article that gives a holistic picture of motivation and impact of demonetization drive.