Pieces of Paper: Demonetisation of Rs 500 and Rs 1000 Notes Explained

Aimed at combating corruption and black money, this move will also cause a lot of short-term pain and chaos for the working class, small businesses and anybody who deals with cash on a daily basis.

Representational photo. Credit: PTI

Representational photo. Credit: PTI

New Delhi: “This has come as a surprise to everybody. The citizens, the nation and even within most of the government!” economic affairs secretary Shaktikanta Das said at a late-night press conference on Tuesday, an hour after Prime Minister Narendra Modi announced that Rs 500 and Rs 1000 notes would cease to be legal tender at the stroke of midnight.

Why was this decision taken? What effect will it have on customers, banks and India Inc? The Wire breaks it down.

Why ban Rs 500 and Rs 1000 notes?

In two words: black money. Unaccounted money, often used in any form of corruption or illicit deals, usually takes the form of high-value notes, which in this case are the Rs 500 and Rs 1,000 bills. In his speech, Modi specifically pointed out that these large-value notes were being used to finance corruption and fund terrorism.

The Financial Action Task Force, a global body that looks at the criminal use of the international financial system, notes that high-value bills are used in money laundering schemes, racketeering, and drug and people trafficking.

In India, the Rs 500 and Rs 1,000 notes also constitute a huge percentage of the money spent by governments, political parties and candidates during general elections. A Centre for Media Studies report showed that nearly Rs 30,000 crore was spent during the 2014 general election, while official spending only accounted for Rs 7,000-Rs 8,000 crore.

This of course only scratches the surface: major industries such as real estate have historically been conduits of black money.

The most important fact, however, is that the share of large-value notes has only been increasing over the years. While some of this is no doubt due to the natural growth expansion of our economy, it also hints at the increasing size of our  black money economy.

Modi’s decision to decommission Rs 500 and Rs 1,000 notes should ideally not hurt most individuals in the long-term, although it will have a significant negative impact on the working class and small and rural businesses in the short-term. Economist Ajit Ranade’s back-of-the-envelope calculation shows that the highest face value in India should be around Rs 250; simply put, Rs 250 is the highest-value note that most Indian individuals should need.

On the other hand, what needs to be noted is that there’s no good estimate for how much of India’s black money is in forms other than currency/physical notes such as gold, jewellery, land or any other form of wealth. Therefore, while banning Rs 500 and Rs 1,000 notes will tackle the black money that is in the form of hard cold cash, it won’t affect other forms of black money. On similar lines, this move will, obviously, have little effect on black money stashed away in foreign tax havens.

How is this going to impact urban consumers, small businesses, large businesses?

Over the next month, there will undoubtedly be a significant shortage in cash supply: not just Rs 500 and Rs 1,000 bills, which are being taken out of circulation, but almost every other denomination as well.

Why? Firstly ATMs will be closed on November 9 (pan-India) and November 10 (in some places). This is being done in order to remove all existing Rs 500 and Rs 1,000 notes from the ATMs and replace them with lower-value bills.

Multiple experts and government officials, however, have told The Wire that this process will likely take one to two weeks in urban and semi-urban areas and up to a month in remote and rural regions. In the meantime, long queues at ATM have already started. People are withdrawing smaller notes to stock up, so there will be shortage in the days and weeks ahead.

As a consumer, if you depend on small notes (which is the great majority of India) to pay for your groceries, household items – it could be difficult over the next one week to do so.

Small businesses, both in urban and rural areas, will find this move downright crippling in the short-term. These businesses are mostly run on cash: they use hard cash to receive payments for services and to make payments for inventory and goods. It’s unclear at the moment how quickly they will be given access to the new Rs 2,000 notes that will be issued.

On the other hand, as analysts have noted, India’s larger and new-age companies will have no problems in making the switch to Rs 2,000 notes.

Traditional sectors, such as real estate or cement, which are politically controversial and where there is larger incidence of corruption and high-value cash transactions, will likely go through a tremendous amount of pain, chaos and restructuring in the next few weeks.

“We have just witnessed a tremendous step towards increased transparency in the Indian real estate industry. The effects will be far-reaching and immediate, and shake up the sector in no uncertain way. Stricter measures against black money have for long been required to help bring about greater transparency, give the Indian real estate sector more credibility and make it more attractive for foreign investors,” JLL India chairman Anuj Puri told The Wire.

The ripple effects of this cannot be understated. There are major industries in India thrive on a parallel economy funded by black money. How will this affect the more legitimate and normal economy? The weeks and months ahead will tell.

How will this impact the vast sections of India’s population who depend on cash?

This move deeply impacts the working sections of society: drivers, maids, cooks, electricians, plumbers. Anybody who provides services in the informal sector and depends on monthly or bi-monthly cash payments.

Why? One obvious example: if you had planned on paying your maid or cook tomorrow and you aren’t able to beat the ATM queues or have enough smaller-value notes lying around the house, they will have to wait to be paid until you can get your hands on some cash. If ATMs are not replenished quickly and often over the next two weeks this could be a very serious problem. The severity of this impact will depend on how easily and smoothly India’s banking system and the government executes the transition.

Stepping back, however, anybody in rural India who doesn’t have access to a bank account (roughly 200-300 million people at last estimate, although the number is likely higher) and depends on high-value cash transactions will be crippled until new notes come through. One argument is that with the Jan Dhan scheme and the UPI/digital payment stack, rural India shouldn’t have too much of a problem. However, it will be a long time before rural India moves to completely cashless transactions.

In the short-term, people in rural India who have a significant amount of Rs 500 and Rs 1,000 notes, but no official form of identification, will have a tough time in exchanging their notes.

How many Rs 500 and Rs 1,000 notes are floating around? How much will it cost to replace them?

The numbers and calculations for this are mind-boggling. According to the RBI press conference today, there are 16.5 billion ‘500-rupee’ notes and 6.7 billion ‘1000-rupee’ notes in circulation right now.

In addition to this, RBI data shows that the share of Rs 1,000 notes in the stock of currency in circulation at the end of financial year 2014-15 was  39%. Rs 500 notes accounted for a further 45% of currency stock.

Putting it simply, at the stroke of midnight, a little over 80% of the cash in India (by value) will be worthless pieces of paper.

How much will this decision cost us? Or more importantly, why will it cost us anything at all? Firstly, because the Rs 1,000 note costs the least to produce as a proportion of face value.  It costs India around Rs 3 to print a Rs 1,000 note (0.32% of face value), while it costs 96 paise to print a Rs 10 note (9.6% of face value).

One analysis has pointed out that the total cost of printing the value of Rs 500 and Rs 1,000 notes issued in 2014-15 in the form of Rs 100 notes would be around Rs 11,900 crore. This doesn’t include the costs involved in increased replenishment and maintenance of ATMs, which would be required because of the usage of and withdrawal of smaller-value notes will be far greater.

Das has pointed out that the exact calculation as to how much this will cost has still not been made. Das pointed out that any economic cost would be outweighed in terms of the benefit it would bring to India and the Indian economy.

What of the new Rs 2,000 note? Why is this being issued at all, if we want to combat black money and corruption by removing large-value notes?

The Rs 2,000 note has apparently been in the works for sometime. A report published by The Hindu Businessline almost three weeks ago (October 21, 2016) notes that Rs 2,000 notes would be coming soon and that the RBI said they had already started being printed and that their dispatch from a printing press in Mysore was underway.

This, however, brings us to the larger question: Why do we need a Rs 2,000 note and a new Rs 500 note if the move is to abolish large-value bills and move towards a cashless society?

One potential answer is that there is still some need, especially among India Inc and small businesses to use cash and the Rs 2,000 note will help. It does seem a little puzzling however. In the RBI and finance ministry press conference today, Das carefully noted that the central bank would cautiously “monitor and regulate the issuance of Rs 2,000 notes in the future”. This means that it is unlikely that the Rs 2,000 notes will be issued in large numbers.

The timing of when these notes will be issued has to be taken carefully into account. One market analyst pointed out to The Wire that if the new notes were released before January (December 31 being the last date by which all Rs 500 and Rs 1,000 notes must be turned in), it would circumvent the whole point of demonetising larger-value notes!

The new notes will also reportedly come with a more secure design, making them easier to track and tougher to counterfeit. Contrary to reports, there does not appear to be a “tracker” on the Rs 2,000 note. However, more details on this are awaited.

Does India stand alone in banning large-value notes?

The idea is certainly not unique or new: It has for the past five years been proposed by a number of academic institutions, think-tanks and international bodies that look to crack down on tax evasion, corruption and terrorism-financing. In February this year, European Central Bank head Mario Draghi announced that they were considering abolishing the region’s most-valuable bank note (the 500 euro bill) in order to curb tax evasion and terrorism financing.

In the same month, former US treasury secretary Larry Summers also recommended that the $100 bill be demonetised.

Peter Sands, a senior fellow at Harvard University’s Kennedy School of Government, in recent times, has done some interesting work regarding banning large-value notes as a means of cracking down on global crime and corruption. An introduction to this work can be found here.

Even within India, there have been some signs that this was in the offing. Two years ago, for instance, the RBI announced that it was phasing out and decomissioning all currency notes issued before 2005. While this was done mostly to weed out fake notes, multiple analysts point out that it was also an attempt at rooting out black money. People who didn’t come forward in the initial three-month exchange period would have to furnish tax and identification proof to exchange large numbers of pre-2005 currency.

The call to retire Rs 1,000 and Rs 500 notes has also been made before within India as well by economists, think-tanks and even politicians.

Could this move have been timed better?

The timing of the announcement has been somewhat of a surprise. While the government has given a number of exemptions to stave off outright panic – Rs 500 and Rs 1,000 notes can still be used for the next 72 hours to pay at government hospitals or for train tickets for instance – it still puts quite a number of people in a pickle if supply of smaller notes are constrained in the days and weeks ahead.

The timing is also curious for other reasons: the UPI (unified payment interface) system is likely to be fully operationalised only by January 2017. Would it have not been better to wait until then, if this move was to also spur India’s shift towards a cashless economy?

On the other hand, if this had been announced in advance it could have been self-defeating in nature; allowing holders of black money to convert their cash for gold or other forms of wealth instead. The secrecy surrounding this decision – coming as it did as a shock to journalistic, policy and even most government circles – only reaffirms this.