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Why did the government opt for demonetization?

In a surprise announcement, the Union Government announced that Rs.500 and Rs.1000 notes would cease to be legal tender from 8 November 2016.Its primary aim was to curb the menace of black money and corruption. It was also targeted at addressing the scourge of fake currency.

Increase in fake currency: The number of fake Indian currency notes in higher denomination has increased during the past few years. Given the similarity in appearance, it is very difficult for an ordinary citizen to distinguish between the fake one and the genuine one.

Black money and terror financing: The black money and the fake notes are also found to be used for anti-national and illegal activities. These high denomination currency notes are being hoarded by the terrorists to finance their anti-national activities.

Economic spiral: It increases the deposits in banks, thereby increasing their capacity to lend. More lending should theoretically boost more activity and infrastructural development. The government can resort to more social security schemes targeting the disadvantaged and needy.

Why is a cashless economy needed?

Cost savings: The cost of producing these notes is substantial. The Reserve Bank of India incurred expenses of Rs. 2,872 crore in 2012-13. Its printing presses had expenses of Rs. 4,700 crore, mainly owing to the cost of paper and ink. This would decrease as there is a switch to cashless transactions.

Boost to GDP: As e-transactions increase, the GDP of the country increases too. In a comprehensive study of five European Union countries, viz. Austria, Belgium, France, Germany, and Portugal, for the period of 2000-2012, it was concluded that the GDP of a (largely) cashless country improves – but the effect is seen only in the long run.

Tax collection: In India, the direct taxes constitute only 35% of the total tax revenue.Only  4% people pay income tax.  This is a clear indication of tax avoidance. The move towards cashless economy would ensure more compliance and increased tax collection, both direct and indirect.

Black no more: It is almost impossible to sustain black markets that often prove damaging to national economies. Amounting to as much as $460 billion a year, India’s black economy lies beyond the reach of the tax authorities, creditors and anti-corruption investigators. Digital payments can be easily tracked and leave a trail. Therefore, going digital will make going black tough.


History of demonetisation

Demonetisation has happened twice in India before 2016. Once in January 1946, and again in January 1978.

12 Jan 1946: First Demonetization

Decision: In Britain, 10 Pound notes were called back soon after the World War II. This was to check black market operations and tax evasion, which were known to have occurred on a considerable scale.The government of India blindly followed its colonial master.

Ordinance: High Denomination Bank Notes (Demonetization) Ordinance 1946 was passed by the then Governor General of India, Field Marshal Archibald Wavell, ceasing Rs. 500, Rs. 1000 and Rs. 10000 to be legal tender.

Outcome: It was almost a failure as most of the notes were exchanged. Out of the total issue of Rs. 143.97 crores of the high denomination notes, Rs. 134.9 crores worth notes exchanged. Thus, just over Rs. 9.07 crores were probably “demonetized”.During the first demonetization, no new currency was introduced and exchanges were made with Rs 100 and lower denominations.

Reintroduction: In 1954, Rs. 1000, Rs. 5000 and Rs. 10000 notes were reintroduced.

16 Jan 1978: Second Demonetization

Background: In the early 1970s, the Wanchoo Committee on Black Money recommended withdrawing certain banknotes. But high publicity given to its recommendations resulted in black money operators getting rid of high-value currency notes. Hence, these suggestions were not implemented.

Legislation: The High Denomination Bank Notes (Demonetization) Act, 1978 was passed in the Parliament ceasing the usage of high denominations bank notes of Rs. 1000, Rs. 5000 and Rs. 10000. Finance Minister H.M. Patel and RBI Governor I. G. Patel were considered the key architects in the development and execution of the policy.

H.M. Patel in his budget speech on 28 Feb 1978 said: The demonetization of high denomination bank notes was a step primarily aimed at controlling illegal transactions. It is a part of a series of measures which Government has taken and is determined to take against anti-social elements.

Was this constitutionally valid? The Constitutional validity of 1978 Act of Demonetization was challenged, on the claimed grounds that it violated the then Fundamental Rights of property, in the Supreme Court.The apex court rejected the plea and upheld the Constitutional validity of Demonetization Act, 1978.

Outcome: This exercise was a near-failure, much as 1946’s demonetization ordinance was.


Key observations

Amendment to 1978 legislation: This act was amended in the Indian Parliament in 1998. Rs. 1000 notes were reintroduced by this amendment due to claims of a shortage of high denomination notes and increasing pressure on lower denominations.

Current demonetization: Old notes of Rs 500 and Rs 1000 are being exchanged with new Rs 500 and Rs 2000 notes.So, it is a straight forward conversion. It will have to be seen how many of these old notes will be exchanged.It is estimated that close to 90% of the old notes had been exchanged till the deadline. If this is validated, it would mean the Finance Minister’s initial estimate – that one-third of the existing 500 and 1000 Rs notes will not be deposited – was way off reality.

The key idea of all these exercises is to demonetize. But if the past two exercises and the trends of the current one are put together, the grand demonetization project is merely reduced to currency exchange programs.

The impact:

Demonetization has adversely impacted the businesses which are heavily cash-dependent.

Hurt private consumption: The Centre’s demonetisation move has hurt private consumption and impacted sectors such as real estate, automobiles and FMCG(fast moving consumer goods), which in turn has altered the economy’s recovery path in the short-term

Real Estate: It has been negatively impacted due to deferring of home purchases by the consumers. Also, developers have deferred launching big projects due to likely fall in the prices of land and properties. Even secondary market (resale) sales have dropped by 50%. But many expect that rate cuts in the coming months would boost this sector.

Consumer packaged goods: There is almost no discretionary spending on these goods. The rural sales are more hurt compared to the urban sales. But in the long term, it should bounce back due to re-monetization of the economy and increased digital payments.

Consumer durables: 80% of the sales that happen in this sector are via cash. But, with many of the firms going digital and offering discounts, even this sector should recover in coming months.

Airlines: This sector has been negatively impacted due to demonetization. This is due to significant reduction the discretionary domestic travels. This forced the airlines to decrease the costs adding to their losses. A similar trend has been observed in the international travels also. But the true impact is still to be assessed when the real numbers of their sales come out in the final quarter.

Automobiles: Most of these firms expect a decline in the sales in the coming months. This is massive for two-wheelers as most of the payments here happen via cash. Hero MotoCorp Ltd, for instance, sold 480,000 units in November, down from a monthly average of 600,000 units.


Infrastructure: This sector is negatively impacted due to decreased power demand, a lesser collection of tolls, etc. Also, the wage payment got affected because of the cash crunch. But more transparency creeps in due to the less cash-dependent system. With economic growth likely to be hit, the government will likely step in and spend more, which will result in increased revenue for the sector.So, in the long term, this sector would experience an overall positive impact.

Unorganised sector: The daily wage labourers, construction workers, etc. were completely inconvenienced. Those who earn and spend mostly or entirely in cash, found themselves rendered penniless overnight.These were the poor of India.

Rabi crops: The demonetization occurred just as farmers were selling their Kharif crop and making their purchases for the Rabi. Spending by farm community hit: Spending by the farming community, which was expected to pick up due to the higher Kharif output and the stronger monsoon, has been squeezed due to despair sales taking place because of the unavailability of cash and the fact that all mandi transactions are carried out in cash

Overall impact: The consumers, with less dispensable cash with them, would become choosy in their spending. This will decrease the demand. Hence, the manufacturers could cut down their production and try to clear off their unsold stocks. Overall, it is expected that the economy will slide down in 2017.

In the run-up to the demonetisation announcement on November 8, private sector investment was on the cusp of a recovery on the back of recovering household demand, easing inflation, and the boost to agriculture due to the stronger monsoon. This momentum has since been lost, and will likely begin to return only in the next financial year.

But it could yield some benefits in the medium- to long-term, provided follow-up measures are taken and there’s no return to an era of inspectors and tax terrorism. Demonetisation will have medium-tolong term benefits for the economy as an increasing share of economic activity gets formalised, not to mention the message such a policy move will send against corruption and black money hoarders.


Who benefitted from this move?

This bold move to invalidate 86% of currency (by value) in circulation has been widely debated. In short term, it has terribly impacted the lives of people and disrupted the economy. Long terms consequences can only be validated in the long run. But there are a few areas or firms that were positively impacted by demonetisation.

Digital Wallets: As people are experiencing a cash crunch, the situation is leading people to digital wallets to pay for their daily necessities. As more users are migrating to digital wallets, the services are adding users at an exponential rate. Firms like Paytm and MobiKwik have experienced a manifold increase in the number of users and the amount of money being transacted.

Organised retail: As most of these firms already have the infrastructure supporting cashless transactions, the impact of demonetization has been largely positive. But the nature of spending has changed to daily needs and essentials rather than luxury goods.

Banking: The impact would be mixed over short-term, neutral to positive in the long term. In short-term, non-interest income for banks would increase, but as the economy slows – asset quality and credit growth could worsen. But over the long term, this exercise should benefit banks because they will likely attract a high share of savings and increased fee income from e-payments.

Tourism: It has experienced mixed results. This was because, in the unorganized tourism sector, where payments happen mostly via cash, there was a slump in hotels and associated services bookings. However, the premium hotel segment has not seen any impact, as bookings are mostly done in advance and online. The negative impact is mostly restricted to unorganised sector.

Microlenders: In the short term, microlending will face problems as these lenders had to defer cash recoveries for some time after demonetization was announced. But, over the long term, demonetization could pave the way for more people to turn to the organised sector for microcredit.

Ratings: The GDP estimates went down. Several brokerages and multilateral institutions, such as the Asian Development Bank, decreased the economic growth estimates for India. However, the fall in consumption had a favourable effect on inflation – retail inflation fell to 3.63% in November.

How is the government making efforts to make India a less-cash country?

To be clear, the demonetisation project was initially projected as an anti-black money weapon. Towards the end of it, there was more talk of making India a cashless country than of capturing all the black money hiding in the form of cash.

The real measure of progress in digitising transactions can only be the degree to which the consumers show a propensity to adopt non-cash methods to pay. As people are increasingly willing to dispense cash, the focus should be on creating an ecosystem that institutionalises non-cash transactions.Governments and businesses are at the core of this shift.

The role of RBI: The RBI can help in easing the situation by offering rate cuts. It will enable struggling infrastructure and real estate companies to refinance their debt and thereby reduce their interest costs.


Measures taken by the government so far:

The government introduced a new income disclosure scheme and tax evaders have been given time until 31 March 2017 under the Pradhan Mantri Garib Kalyan Yojana.

Encouraging digital payments: The government unveiled a series of measures to encourage digital payments. It offered discounts on petrol, railway tickets, toll payments and insurance policies. It has requested all the banks to waive fees on debit and credit cards and install an additional one million point of sales (PoS) terminals in three months.

The government recently announced the Lucky Grahak Yojana and Digi-Dhan Vyapar Yojana to encourage people and merchants to use digital modes of payment.

The Bharat Interface for Money (BHIM) was rolled out to enable fast, secure and reliable cashless payments through mobile phones. It can be used on all mobile devices. It uses UPI, and the money stays in your account, unlike other digital valets.

Way forward

G2P payments: Government to Person disbursements include pensions, government salaries, small savings schemes and social welfare schemes such as Mahatma Gandhi National Rural Employment Guarantee Act (MGNREGA). For example, 80.7 million bank accounts are registered under MGNREGA. Enabling more people to receive government payment on their mobile or online accounts is a good way forward.

Overseas transactions: The peer-to-peer transfer of funds and cross-border shopping should be strictly cashless.

Small and Medium Enterprises (SMEs) can adopt non-cash methods such as invoice and payment automation which could lead to a reduction in late payments, processing issues, etc. As more customers are willing to make their transactions online, SMEs could be enticed into noncash transactions as they are more transparent, cheaper, less risky and easier to maintain.

Targeted programs: The government can also institute programs that meet the needs of the underserved segments such as farmers and women. It must collaborate with microfinance institutions in states to strengthen financial participation in the last mile. The newly launched Payment Banks have come just in time to promote a ‘less cash’ economy.