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Monday, December 5, 2016

Scrapped Currency: Unintended Consequences

In a bid to check black money as also to eliminate fake currency that is being mostly used to fund terror activities, Prime Minister Modi announced the withdrawal of 500 and 1,000 currency notes as legal tender with effect from 8th November. The result is: 23 billion currency notes have become junk. Which means, cash circulation in the country has in one go come down by 86%. This has obviously made even buying vegetables harder. And for all those hundreds of millions who work in the informal economy particularly in the countryside, life has become a challenge, for, their commerce has come to a halt.

Interestingly, this sudden clamp down of the scheme of scrapping the extant high value notes and replacing them with new notes that was planned and carried out by the Reserve Bank of India and the officials of the government with such an utmost secrecy is in itself highly remarkable. For, one it testifies that the nation’s civil administration set up is equally responsive to the demands of the political leadership, once the sincerity of purpose is well exhibited by it, and two, it ensures that tax-evaders, counterfeiters, and corrupt officials and politicians hardly get a chance to exchange their ill-gotten hoards for gold and such other assets.

That said, it must also be admitted that as the subsequent events proved, the government does not appear to have planned well for mitigating the impact of sudden ill-liquidity imposed by the withdrawal of high denomination currency notes. In an economy, that is, known for most of its transactions being carried out in cash, failure of logistics in replacing the currency has only disrupted the economy, for, money is its lubricant. The misery is worst in the countryside. Even in the urban centres, banks could not cope up with the demand made on it for exchange of currency and the result is: a hue and cry against the banking system.

But the task of replacing around 23 billion pieces of currency notes for 1.3 billion citizens by 1.3 lakh bank branches is not an easy task. Indeed, it is an unprecedented demand. No country has ever undertaken such a gigantic task in peace time, that too, when the economy is trickling along alright. Kenneth Rogoff, Professor of Harvard University has, of course, been recommending scrapping of high denomination notes but in a phased manner, that too, for developed countries. What government of India did therefore is an extremely ambitious programme.  Yet, in fairness to the banks it must be said that they have been handling the demand like real heroes that too in the trying circumstances.

As this suffering is going on, economists say that the current move is good in the long-term interest of the country, for, it is likely to broaden the formal economy and thereby improve the tax compliance. Secondly, the exchange process of notes likely to improve banks’ deposits substantially, which means increased lendable resources. Indeed one estimate puts the likely accretion of deposits at a whopping 15 lakh cr and if even a 10% of it remained as deposits, the interest rates are sure to fall further down making long-term investment attractive. Thirdly, the fear of government repeating such an exercise once in a while is certain to bring behavioural changes among the public which shall reflect in the form of money flowing into tax-free investments such as mutual funds and capital market investments. All this cumulatively paves the way for growth in GDP, of course, in the long run.

There is however, a flip side to it: the ban on notes is certain to result in a fall of 1% in GDP growth in the current financial year. Secondly, as the real estate prices are likely to see a correction as high as even 50%, the value of collateral securities of banks likely to erode considerably, which means a fresh wave of balance sheet stress for banks. Thirdly, with a further fall in interest rates on deposits, senior citizens will be the worst sufferers, demanding for alternate means to improve their income for their subsistence. And, most importantly, creation of black money being not a one-time affair, a fresh cycle is certain to start, once the exchange is over.
So, what the government urgently required to do is: speed up the note exchange process to arrest the acute distress and also to put the economy back on wheels and initiate effective monitoring measures for tax-compliance to minimize further creation of unaccounted money.
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