Rs 1000, Rs 500 notes scrapped: What it means for you, me, and the guy who sells tea on the pavement

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).

The only curious thing, though, is that the mandate for issuance of currency notes and monetary policy at large is with the RBI and not with the government of India. Thus, the announcement should technically have come from the RBI and not the Prime Minister. However, one has to take cognizance of the fact that an RBI notice would not have had the same effect. Going forward though, the onus lies on the Reserve Bank to ensure that there is some sort of business continuity and a smooth transition, though it would be far from easy to achieve this. The RBI has to ensure that there is enough liquidity in the system to satiate the demand for cash. ATMs have to be refilled continuously and new 100 rupee and lower denomination notes have to be printed in large numbers, which obviously has a large transaction cost to the economy, as Karthik Shashidhar points out.
Such a move has huge ramifications for the country and it would be fair to say that nobody truly knows about the entire range of effects, since it is prone to touch so many sectors and aspects of the economy. However, certain things can be gleaned quite easily.

The intended consequences:

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.

It is important to note that this is necessarily a one-time clean sweep of unaccounted money and will definitely go a long way in reducing the stock of black money in the economy. However, it would be meaningless if enough measures are not taken to curb the sources and flows of black money. The new 2000-rupee denomination would make it easier to hoard cash. Long-term measures need to be taken to curb the flow of unaccounted income in India and encourage economic activity to move out of the black market and into the formal sector. If not, we will be in the same position as we are in today, say, five years down the line.
The move will have a higher success rate against counterfeit notes, again, with a one time sweep of all the stock and a definite reduction in the future flows, given the new security features promised in the new 500 and 2000 rupee notes.
A line of caution, though. It is rather naive to retain the image of mattresses lined with 1000 rupee notes or cupboards full of bank notes. A lot of the black money would have periodically been converted into other assets, such as land, gold and even luxury cars. Also, it is important to note that expensive goods can also replace cash as tools for bribery. iPhones and other luxury items can be given under the table just as easily as cash. Notwithstanding this caveat, the move can definitely be expected to make a sizeable dent in the stock of black money and counterfeit notes.

Unintended Consequences:

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.

Further, all of agricultural income is tax-free and a majority of the transactions takes place using cash. It will be extremely difficult for them to exchange their cash at banks, as they will have no receipts or bills to prove that it is earned legitimately. It should also be remembered that despite all the measures of the present government, penetration of banking services remain woefully low. A large part of rural India and the urban poor simply do not possess a bank account, into which they can deposit their legally and hard earned money. In India, the number of people without a bank account is around a quarter of a billion. There is currently no alternative for them to convert their large denomination notes to the legal tender. This is an issue that the RBI or the government has to take up immediately in order to mitigate the crippling effects of such a move on the financially weaker sections of society.

The economy will also have a turbulent time in the coming days, at least until the new notes are in place and in circulation. Retail sales will crash across the board. E-Commerce websites have either already removed or will remove the option of cash on delivery. Overall transaction costs in the economy will increase in the short run. This is a non-trivial cost to the economy.
There will almost certainly be a slump in the real estate sector. A large number of real estate deals are settled using cash. This will take a hit and will take time before recovery. However, the market correction in the real estate sector was perhaps overdue anyway.
Finally, there will be a slump in real economic activity. Cash, whether accounted or unaccounted, was the primary mode of transaction in the economy. A liquidity crunch will definitely depress economic activity in the short run.
The move is also likely to give a boost to digital payments. Notwithstanding the reissue of the larger denomination notes later on, the volume of digital payments and the number of bank account holders are definitely set to increase, but will not directly result in a push towards a cashless economy, which bears its own costs and benefits. (Read my analysis of what a cashless economy would entail here).

How will this pan out eventually?

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.)