The state’s unleashed its ultimate weapon

Any decision to withdraw the legal tender status of currency in circulation creates a sense of confusion and some despair. The monopoly rights of the sovereign to issue currency notes and coins are asserted in reverse in demonetisation episodes for achieving economic and political goals that seem difficult with normal policy measures.

Its economic costs and benefits are hard to assess ex ante . More importantly, only a few among the population have a clear idea of how demonetisation could deliver the intended outcomes. Even under the best of circumstances, it’s a hard sell for any government.

The demonetisation announced at prime time on November 8 is among the rare, bold economic policy decisions in the history of independent India. It is clear that that a good bit of planning and preparation involving the ministry of finance and the Reserve Bank of India were completed beforehand.

That this was done in absolute secrecy is no small feat. To be fair, the authorities have identified nullification of black money hoarded in cash, tackling of counterfeiting Indian currency notes, and curbing of terror financing with fake currency notes as the three objectives of this round of demonetisation.

But quite a few commentators and analysts have opined that this will engender a marked fall in the use of cash transactions in India and thus pave the way for the transition to a ‘cashless’ economy.

To be sure, this measure will cause some hardship to the people for the initial few weeks. And it is quite likely that the section of the population that lives outside the banking system will be affected the most. Some fall in demand, particularly in all retail sectors is possible.

However, it seems that the RBI has planned reasonably well to use its own offices/branches as well as about 1,34,000 branches of banks in the country to collect the demonetised notes and supply new currency notes, including notes of a new series of ₹500 and ₹2,000 denomination to minimise disruption in the economic and social lives of people.

Currency management is one of the RBI’s less glamorous functions that does not attract public attention except in times such as this.

However, the RBI has the institutional capability to mobilise and manage its resources, including experienced and skilled manpower.

Comparisons with the last demonetisation, effected by the Morarji Desai government in 1978, though natural and somewhat compelling, are not realistic both in terms of economic impact and scale of the logistics involved.

Demonetising high-denomination notes — ₹1,000, ₹5,000 and ₹10,000, also known as registered notes — in 1978, was a tame and a largely inconsequential affair.

These three denominations together accounted for less than 10 per cent of the value of the notes in circulation then.

Very few would ever get to see a high-denomination note in their lifetime. The exercise redeemed close to 95 per cent of the value of these notes in circulation, thereby generating negligible fiscal gain. The last date for the tendering of demonetised notes was extended by the RBI, which caused some controversy.

India is a cash-dependent economy. Its cash to GDP ratio, at 11 per cent, is much higher than in most economies. Close to 98 per cent of all consumer payments are made in cash. Financial technology companies in the payment services sector are upbeat that demonetisation will also mean a big digital push for India. Some of them have even seen a spurt in business in the wake of the demonetisation announcement.

Seen against the setting up of the Unified Payment Interface (UPI) in August this year and the reported plans of the Government to prohibit cash transactions involving ₹500,000 or more, there are reasons to be hopeful that India will leapfrog to much lower dependency on cash over the next five years.

The main yardstick to evaluate the success of demonetisation will be the resultant fiscal gain accruing to the RBI and, hence, to the Government.

According to the latest RBI data (end-March, 2016), the notes of ₹500 and ₹1,000 denomination together constitute, in value terms, 86.4 per cent of the total notes in circulation. Their aggregate value is ₹14,180 billion (₹14,180 crore). Over the last few years, the annual growth rates of the circulation of notes of these two denominations have largely tracked the growth rate of nominal GDP, indicating no sudden spurt in their demand.

The size of the black economy in India is estimated to be in the 20-25 per cent range. It is safe to assume that the structure of the black economy, including that of its ‘cash component’, has been fairly stable over the years.

This leads another safe assumption that the proportion of black cash in the aggregate currency in circulation is also around 25 per cent. In fact, it should be higher than 25 per cent, given the higher preference for cash in the case of tax-evaders vis-à-vis others.

The demonetisation will, therefore, be a success if the fiscal gain is at least 25 per cent of the value of the ₹500 and ₹1000 notes in circulation, that is, ₹3,545 billion, equivalent to about $53 billion. The fiscal gain is the sum of the value of the ₹500 and ₹1000 notes that will not be tendered for exchange or for credit to bank accounts plus the penalty that tax-collectors will levy on those with mismatch between the notes deposited and their respective declared incomes.

Demonetisation of the huge scale that is currently under way in India is like wielding a sledgehammer at an enemy that has long evaded subjugation because of its sheer heft and some benign negligence on the part of those whose duty it was to confront it head on.

It will be interesting to see how the Government deals with the rising cacophony of opposition to this move. The denouement will indicate how the rest of the term of the present government will be like.

The writer is a former central banker and consultant to the IMF. Via The Billion Press