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Demonetization in India as recent as it may sound dates back to 1946, when 5,000 and 10,000 rupees notes, the highest denomination notes ever printed were put out of circulation.  These notes were demonetized in 1946 and again in 1978 after an impermanent reintroduction in 1954. [i]

The issue of these high denomination notes seems to be in contrast to those countless classic tales recounted by grandparents, of times when 10 grams of gold could be bought in under 90 rupees, when plots were worth mere thousands and innumerable others underscoring the same message of how the value of money has dissolved over the past several decades.

This poses a natural question, why would notes in denominations of 5000 and 10,000 be introduced in such a time as this?

The Central government, authorized by the Reserve Bank Act of 1934, can direct printing of bank notes up to denominations of ten thousand rupees even today. The denominational value of various bank notes are specified by the central government based on recommendations of the Central Board of the Reserve Bank.

Quantity of the notes in circulation is one of the cardinal variables which influence the denominational value of bank notes along with inflation. The Reserve Bank is responsible for determining the quantum of notes of each denomination to be printed. In order to maintain price stability, one of its key responsibilities as per the provisions of the Reserve bank Act 1934, the Reserve Bank estimates the demand for each denomination based on factors ranging from GDP growth, inflation, to the number of soiled currency notes.

The economic conditions prevailing at the time the Moraji Desai government took over were intense. The first oil crisis and deficit financing for funding the costs of the 1971 war led to a historic inflation rate of over 30 percent, fomenting political and social unrest in the country. The link between resource prices and inflation exacerbated the problem.[ii]

Demonetization in this time was an attempt to curb ‘the illicit transfer of money for financing transactions which were harmful to the national economy’ and to restrain the volume of bank notes in circulation. However, the former RBI governor IG Patel was not in favour of the step as he felt that it could be perceived as a measure targeted at the “corrupt predecessor government or government leaders”.[iii] 

 

Source: http://www.inflation.eu/inflation-rates/india/historic-inflation/cpi-inflation-india.aspx

 

The recent demonetization policy claimed to be an action aimed at resolving issues that have beset the economy even after the first venturesome move to demonetize the high currency notes. These issues concern corruption, counterfeit currency, terrorism and black money. In contrast to IG Patel who openly disfavored the move, the incumbent RBI governor was in support of the move.

Since a reasonable amount of time has passed since the implementation of the policy, some inferences can be drawn based on the claimed benefits. Inadequacy of data limits the scope of cost and benefit analysis however a qualitative analysis of the policy is befitting.

Benefits or costs of demonetization can be perceived as direct and indirect. The direct benefits or costs would be in terms of the amount of earnings generated or costs borne as a result of the implementation of the policy. The revenue sources include, inter alia, a reduction in liability and increased tax revenue while the expenditure includes costs incurred for printing of new banknotes and implementation of the policy. There are multitudinous indirect or qualitative benefits and costs involved with this policy; some selected factors are discussed in what follows.

One of the implications of the policy was an increase in the number of deposits and reduction in the number of notes in circulation. This can have short and long term effects on consumption patterns.

Impermanent disinflationary pressures developed in the short run as a consequence of fall in the demand of goods and services caused partly by the shortage of hard cash and partly by the unimaginable amount of time spent by individuals standing in queues. 

The long run consequences on consumer demand are explained by a theory of cognitive bias relating to currency proposed by Raghubir and Srivastava (2009). The denomination effect, argues that consumers tend to restrain spending of higher currency notes as compared to spending smaller denomination bills of an equivalent value. Thus the issue of the 2000 Rupee banknote is bound to affect the spending behavior in India, which could possibly lead to a period of lean consumer expenditure and growth. 

An increase in the number of deposits also influences the credit availability in an economy. A boost in credit caused due to increased cash deposits underpins higher investments in the future.  The banks are profitable as long as they gain from the difference between the interest received on loans and the interest paid on deposits. Swelling up of deposits without a significant increase in lending could result in losses. This necessitates lower interest rates in order to provide a stimulus to credit. This would then translate into higher investment in the economy, fueling growth. As is evident the lending rates have fallen post demonetization. Another implication of the increased deposits was the reduced deposit rates. 

The sizable increase in deposits had also caused surplus liquidity in the banking system. To foreshorten this surplus the Reserve Bank ordered an additional cash reserve ratio for a brief period post demonetization. The cash reserve ratio is a fraction of deposits the commercial banks are required to hold as reserves with the central bank. The growth in deposits relative to the credit created by banks was the major source of the surplus liquidity in the system. The incremental CRR was intended to absorb the excess liquidity prompted by the return of demonetized notes. The banks were required to maintain incremental CRR of 100 percent for the increase in deposits between September 16 and November 11.[iv]

The reform has also brought about a definite increase in the spending capacity of the government. An observable effect of the entire process is the reduced liability of the Reserve Bank of India since the demonetized notes are now recognized as cancelled liabilities. The Reserve Bank of India is no longer liable to pay the bearer of the old 500 and 1,000 Rupee notes. This can have a significant impact on the government budget and its spending capacity.

The 500 and 1,000 Rupee banknotes in circulation were worth 14.86 lakh crores according to the Annual Report of the Reserve Bank of India, 2016. However the amount turned in was 0.4 trillion short. The Reserve Bank of India could choose to increase the currency liability by this amount to fund government expenditure thereby recycling this money back into the economy. With the inflation targets met early on, the government can provide a fiscal stimulus without worrying about inflationary consequences. Thus the government stands to gain from removal of counterfeit notes and the unaccounted money in circulation while also benefiting from a fifty percent income tax charged on the amount of black money unearthed.

The move was put in another light mid process, attributing the inadequate supply of the new notes after the declaration of demonetization as a course to the virtues of digitalization in the cash driven economy. This proved to be extremely beneficial for electronic payment providers. There has been a spike in downloads and account creation for multiple digital payment applications. The growth nonetheless was limited to the period of cash shortage. E-wallet usage has gone down by 50 per cent in the first few months of 2017. In contrast UPI and BHIM transactions have consistently risen. The debit card usage which had also shot up post demonetization has seen a limited decline in the number of users.  Digitalization in India will have the ability to make transactions accountable and track-able, which can prove to be instrumental in transitioning from the informal to the formal economy.

However when social or the actual costs are matched with the perceived benefits, it is questionable whether a comprehensive analysis of the potential gains and outlays was conducted before the implementation of the policy. Corruption, a problem inherent in the system may have contracted due to the reform however the effects will be foreseeably transient as no subsequent policies to counter this issue were announced. The growth in GDP fell only marginally as the slowdown caused by inadequate cash and breaking supply chains was partly offset by positive growth effects of low oil prices.

Source: http://www.indexmundi.com/commodities/?commodity=crude-oil&months=60

The implementation of the policy has also been widely criticized for lack of planning. It has caused more harm to legitimate businesses and earners than hoarders of black money. Thus as an attempt to curtail black money and corruption, the policy has been unsuccessful. It has had limited benefits with exorbitant costs and unclear objectives.

 

 

 

 

 

 

References

[i] http://www.deccanchronicle.com/nation/current-affairs/091116/scrapping-large-currency-not-new-in-1946-india-demonetised-rs-5000-10000-notes.html

[ii] https://www.quora.com/What-caused-the-1974-Indian-inflation-to-skyrocket-to-more-than-a-whopping-30

[iii] https://www.thequint.com/india/2016/11/09/rs-500-1000-notes-scrapped-narendra-modi-a-look-back-at-1977-when-notes-were-scrapped-demonetization-black-money-rbi

[iv] http://www.thehindubusinessline.com/money-and-banking/banks-told-to-maintain-addl-average-daily-balance-with-rbi/article9389836.ece

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Written By Radhika Arora

An Undergraduate Economics Student

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