Demonetization - Indian Economy demonetizing almost 97% of currency in circulation. Its causes, benefits and efficacy summarized into one.
Demonetization?
Let us start with a simple question. What is demonetization?
“Deprive (a coin or precious metal) of its status as money”
“To officially stop using particular notes or coins, or a particular currency: In 2002 the currencies of twelve European countries were demonetized and replaced with Euro.”
Since, we have familiarized ourselves with the definition of demonetization and when it was last used on a large scale, now we can go deeper into the causes of demonetization.
Causes behind demonetization
Black Money: Black money is generated when payment of tax is avoided by a company and pure cash payments are undertaken. Companies undertake round tripping and transfer mispricing to save taxes from the Government and then the same is invested again the economy through tax havens. In this manner, huge amount of cash holdings are generated which are unaccounted for in the eyes of law and are to be disposed of, since, as per the tax authorities that money does not exist in the economy.
Corruption: The black money generated is used to feed the corruption in an economy. This money is used to buy preferential treatment from Government, Organizations, individuals in order to get the work or acts done which otherwise would not have been undertaken or would take longer periods if done without the incentive of money. The ill-gotten money when reaches the individuals is used to buy services in i.e. labor intensive operations and luxurious services which do not leave traces behind in the form of assets.
Fake Currency: The menace of fake currency affects an economy with inflation, when fake currency enters into circulation it will lead to an increase in inflation with more demand and less supply. With the existence of fake currency, the monetary policies of the Central Banks of the country become less effective. Inflation in the economy goes beyond the control of the central bank and measures to control it are rendered useless.
Underground Economy/Banking: Although, it is not an illegal but it becomes an easy getaway to launder black money. Underground economy keeps plenty of currency and transactions hidden from the Government and banks since it currency exchanging hands. Some of the most common examples of underground economy are paying salaries in cash, remittances done in cash.
Illicit Funding: The funding of illicit activities such as bribery, extortion, terrorism funding, drug trade is done through cash only, since, these activities are illegal. Hence, the transactions of these activities are undertaken in cash only.
Cash Oriented Economy: An economy which is heavily dependent on cash transactions is bound to have plenty of revenue leakage. An economy which has a large chunk of employment in unorganized sector loses a large portion of its revenue to under reporting of profits and over reporting of losses.
Benefits of Demonetization
Move towards cashless society: One of the biggest benefits that accrues out of demonetization is that a society willingly or reluctantly moves towards cashless operations. Out of need or out of knowledge populace learns about cashless nature of transactions. This makes movement of currency relatively safe and saves precious man-hours which otherwise would have been wasted in conducting the manual transaction.
Removal of corruption: Among the benefits of demonetization is considered as removal of corruption. It is quite pertinent to mention here that in a developing economy where corruption exists at all levels, it is the one in the lower levels which gets impacted. It is the corruption which exists for basic and lower level of services gets impacted. It is the corruption which is purely currency oriented corruption.
Revenue growth of the Government: With a move towards cashless economy more and more transactions come under the purview of formal banking system. Recording of income as well as expenses also results in imposition taxes such as service tax, sales tax, income tax which ultimately leads towards the growth of government revenue and development of the nation.
Reduced cash holdings: Demonetization with itself brings a disincentive to hold less cash holdings with citizens even though the holdings might be having transparent character. It brings this cash holding into the formal economy where it can be further used for its money multiplier effect by the banks.
India – A Demonetization Case Study
Probably, one of the biggest questions on the minds of people now a days. It has indeed turned the entire populace of this country into economists. People are debating over the issue of demonetization are divided into two categories i.e. those who are in favor of it and the ones who are against it.
The Government of India on November 8, 2016 decided to withdraw Rs. 500.00 and Rs. 1000.00 notes from circulation and announced that both these currencies cease to be legal tender with immediate effect. Although, a few options such as Hospitals, Petrol Pumps, travel tickets counters were allowed to accept such currency. The general populace was given time till December 31, 2016 to deposit their money in the form of old notes to be deposited in the banks. The process is still going on with plenty of deposits being made and also several Income Tax raids on depositors with dubious deposits.
Beginning with the fact that neither the Government of India nor RBI has labelled this act as “Demonetization.” This action is being called as withdrawal of legal tender character both by RBI and the Government of India. Since, demonetization renders even keeping of and old currency as an offence. And moreover, demonetization can only be done by amending the RBI Act while in the case of other only a notification in the gazette is sufficient.
This move is being reviled and lauded in equal measures by the opponents as well as proponents. It is not the first time that demonetization or withdrawal of legal tender has taken place in the economy, it has happened earlier in the time too.
Indian specific History
Earlier in the history also, RBI had gone for demonetization, which was in the year 1946 and 1978. In the year 1946, the notes of denomination Rs. 1000.00 and Rs. 10,000.00 were demonetized. And in the year 1978, Rs. 1000.00, Rs. 5000.00 and Rs. 10,000.00 bank notes were demonetized. Again in the year 2014, RBI had issued guidelines regarding withdrawal of pre 2005 Rs. 500.00 and Rs. 1000.00 notes. Although, they were not withdrawn as legal tender but were barred from transactions.
Unlike history, when the size of Indian economy was nothing as comparable to the current size. Neither there were exports nor imports of the order as they are today. This move has sparked reactions existing on both sides of spectrum. But this withdrawal of legal tender which constitutes in excess of 95% of total amount of currency in circulation has a plethora of dimensions to itself. These dimensions help us understand that why this move was relevant particularly in context of Indian economy.
Economics Dimension: In a developing economy such as Indian economy, the transparency can be brought out only when the common folk is ready to embrace the cashless system. And this move will certainly help in ramping up the revenue streams of the government. But in an economy where large employments are in the informal sector and that chunk is the one which will be most negatively affected by this move, till the time things get back to normal.
Political Dimension: Various political parties are cheering as well as jeering this move. All except the ruling parties are against move citing concerns for the common man and the fact how it has affected only the lowest strata of the society. And it is quite true, in fact the long queues outside the ATMs as well as banks are replete with those people who belong to the lowest rungs of the Indian society. And the people in the long queues had little or nothing to do with corruption or black money.
Legal Dimension: The legal dimension considered here is that the Government has stepped on the authority of RBI and given the face of Prime Minister to a move which was already in pipeline by the RBI. Even the Indian courts have also taken the hands off approach by quoting that this as an executive decision and refusing to stay the move. Legally speaking, the Government is on sound footing, with this one.
Financial Dimension: Withdrawal of legal tender has led citizens to deposit their currency in the bank and it has provided banks plenty of low interest deposits. The deposit has also taken place in the accounts which were previously non-performing assets. The banks which were previously reeling under the burden of burgeoning NPAs and costly deposits have been given a fresh lease of life with this demonetization. This will certainly improve their financial standings.
Dimension of Corruption: One of the biggest benefits lauded of this move is corruption removal. But this may not be the scenario as such when it comes to Indian economic or political set up. In India, it is only the corruption lower levels which is funded out of cash. And it is not that everyone who gives bribes pays them out of their black money. But there exists another insidious form of corruption, the corruption which is in the form of favors, the corruption which feeds on taxable money, corruption which takes place in the form of assets generation. This form of corruption is barely impacted by demonetization or any other form of move which is taken in the economic sphere.
Dimension of Black Money: As long as there exists paper currency in the economy, the problem of black money will be there. It exists even in the most developed of countries such as the US. The existing chunk of black money might get uprooted for now but as soon as the new currency gets hold in the market, the problem would soon creep in.
Dimension of Illicit Funding: Certainly, illicit funding will be checked with this one and gradually as the economy moves towards the cashless aspect this might get reduced to very little. Since, most of the illicit trades are done on cash to cash basis, the withdrawal of legal tender will put a severe dent on this aspect.
Summary
Based upon the above analysis it can be safely said that the economy will be better off with the move of the Government. And the best and the only benefit will accrued in future and that will not erode with the passage of time is the movement of economy towards a cashless one. The common folk will start using technology more and more to their aid their financial transactions and the Government will be richer by the revenue generation. All the other benefits as propounded will either erode over the period of time or quantum of their accumulation will be negligible to very little.