In an address that shocked the nation, Prime Minister Modi unveiled his boldest move yet in the government’s fight against unaccounted money (popularly and politically incorrectly known as ‘black money’). All Rs 500 and Rs 1000 rupee notes will be demonetized or scrapped and will no longer be accepted as legal tender with effect from midnight of November 8, 2016.
It is quite impressive that a policy of such magnitude was genuinely surprising and that it was maintained as a closely guarded secret until the PM’s address (barring a few stray WhatsApp forwards that most people dismissed as baseless rumours).
To get a sense of how big this move is, consider this statistic: around 84% of the value of banknotes currently in circulation is large value notes, with the 1000-rupee note accounting for 39% and the 500-rupee note accounting for the remaining 45% of the currency stock. Thus, as of November 9, 84% of the currency in circulation in India is not considered legal tender.
In terms of implementation strategy, the government has got it right so far. A move such as this has to necessarily be a shock and must have limited time for adjustment. If the adjustment time is large, it gives ample scope for the targeted sections to convert their unaccounted money into other assets. This was the exact modus operandi the last time the government demonetized large value notes in 1978 (for a fascinating account of how that was managed, read this short Mint article).
Thus, as of November 9, 84% of the currency in circulation in India is not considered legal tender.
The raison d’être of demonetizing large denominations is to target unaccounted money and counterfeit notes. A large part of Prime Minister Modi’s election campaign focused on fighting the presence of black money in the economy. Any steps it had taken in this direction had not yielded fruitful results and this rather drastic measure is the inevitable final resort.
The government has allowed citizens to deposit their large denomination notes with their banks, provided they can prove that it is from an accounted source and that they can provide identification. Crucially, there is also a weekly limit of Rs 20,000 on the amount of withdrawals that can be made from the bank in the next few weeks. This is partly to ration the precious Rs 100 notes and also to curb large exchanges of black money for white. By this move, most legal holders of cash will not end up losing money, while the holders of black money would be extremely wary of depositing their money in bank accounts, which can leave a trail for income tax authorities.
Holders of black money will be wary of depositing money in bank accounts, leaving a trail for income tax authorities.
There is bound to be a massive disruption to the economy in the coming few days. Some are bound to be of a temporary nature, while others will have lasting effects.
Immediately, a lot of people are bound to be inconvenienced. The night of the announcement already witnessed long queues in front of the ATMs (though this doesn’t make sense as it would dispense the now defunct large denomination notes), at petrol stations, supermarkets and any other avenue where people could exchange their high denomination notes for goods and services. Going ahead, there is bound to be mini bank runs, long queues at bank branches, and a general liquidity crunch. Given that all banks are compulsorily closed on the 9th of November and ATMs closed for the next couple of days, it is inevitable that a large number of people will find it difficult to carry on day-to-day transactions.
However, inconvenience is a cost that can be borne, given the larger benefits to society. The middle-class and above can temporarily use their debit and credit cards for transactions and will, in all probability, have a variety of instruments for carrying out financial transactions at their disposal. The real cost, however, will fall disproportionately on the poor. A large section of our society still relies on cash for their transactions and for savings. In the short run, the liquidity crunch will really hurt the daily wager who gets paid in cash at the end of day. It is impractical to expect the housing contractor to pay the 15 construction workers he hires in 100 rupee notes.
The real cost, however, will fall disproportionately on the poor. A large section of our society still relies on cash for their transactions and for savings.
In India, the number of people without a bank account is around a quarter of a billion
The bold step has been taken and in a single stroke has managed to eradicate large amounts of unaccounted money in the economy. However, a lot of issues need to be addressed to make this move a complete success and to ensure that it is not a temporary measure that gets reversed with the flow of time.
Immediately, the RBI has to ensure that the transaction costs remain as low as possible. It should have had the foresight to release enough number of 100 rupee notes and must ensure that the new 500 and 2000 rupee notes get into circulation within a reasonable amount of time. Of utmost importance is that the government comes up with measures to allay the fears of legitimate cash holders and find means to make sure that the poor are not robbed of their earnings or savings.
In the larger picture, the government needs to come up with a comprehensive strategy to counter the sources of black money, such that there will be no circular return to the starting point. Else, this entire exercise, which has significant costs, will end up being futile.
(Anupam Manur is a Policy Analyst at the Takshashila Institution, an independent and non-partisan think tank and school of public policy. He tweets at @anupammanur.)