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A PROJECT SUBMITTED TO
UNIVERSITY OF MUMBAI
FOR PARTIAL COMPLETION OF THE DEGREE OF
MASTER IN COMMERCE
IN
(ACCOUNTANCY)
BY
JOLLISON FRANCIS GOMES
UNDER THE GUIDANCE OF
PROF. GATTING KOLI
(M.A, M.COM, NET)
ST.JOSEPH COLLEGE OF ARTS AND COMMERCE
SATPALA
VIRAR (W)
CERTIFICATE
Sr .No. TOPICS
1 Executive Summary
2 Research Methodology
Objective of Demonetisation
Scope of Study
Data Collection Method
3 Introduction
Introduction
Evaluation
History
Definition
4 Review
8 Bibliography
1. Executive Summary
This study will helpful for the citizens of India, Indian government, businessman
and the Indian customers. Through this study government will be able to know
about the future conditions of the economy. This study will help to the government
for policy making to the betterment of the economy. This study will also helpful
for the Indian citizen because they would be able to know the present and future
condition of the economy and they can take rational decision on their income and
expenditure. Any businessman can also take the wise decision so that he will be
able to generate more revenue and can earn the profit in the actual market scenario.
Finally everybody would be able to know the impact of note banned decision on
Indian economy as well as Indian markets.
Secondary data is collected from library, text books, and journals, articles from
newspapers and from relevant websites available on internet.
3. Introduction
3.1 Introduction
The argument posited in favour of demonetisation is that the cash that would be
extinguished would be “black money” and hence, should be rightfully extinguished
to set right the perverse incentive structure in the economy. While the facts are not
available to anybody, it would be foolhardy to argue that this is the only
possibility. Therefore, it is imperative to evaluate the short run and medium-term
impacts that such a shock is expected to have on the economy. Further, the impact
of such a move would vary depending on the extent to which the government
decides to remonetise. This paper elucidates the impact of such a move on the
availability of credit, spending, and levelling of activity and government finances.
3.2 Evaluation
3.3 History
Paper Money as a legal tender was first introduced in the late eighteenth century.
The Victoria portrait series was initially issued in few denominations of 10, 20, 50,
and 100. Then the Victoria portrait was replaced by the following under print
series in 1867. Rs.1000 and Rs.10, 000 currency notes were circulated
between 1938 and 1946. Notes in Ashoka Pillar watermark series in Rs
10 denomination were first issued between the year 1967 and 1992, Rs
20 in 1972 and in 1975 and Rs 50 in 1975 and 1981 and Rs 100 was
launched between 1967-1979. The banknotes issued during this period
carried the symbols which represent the science and technology, patron
and orientation to Indian arts. In 1980, the legendary Satyameva Jayate
— ‘truth alone shall prevail’ — was incorporated under the national
emblem for the first time ever. The highest of all denominations ever
printed and circulated by the Reserve Bank of India (RBI) was the Rs 10,000 note
in 1938 and was issued again in 1954. Mahatma Gandhi (MG) series banknotes
were issued in 1996 in the denominations of Rs 5, (introduced in November 2001),
Rs 10 (June 1996), Rs 20 (in August 2001), Rs 50 (March 1997), Rs 100 (in June
1996), Rs 500 (in October 1997) and Rs 1,000 (in November 2000). The Mahatma
Gandhi Series – 2005 bank notes were issued in the denomination of Rs 10, Rs 20,
Rs 50, Rs 100, Rs 500 and Rs 1,000 and carried some additional/extra security
features as compared
to the 1996 MG series. A new redesigned series of Rs500 banknotes and a new
denomination of Rs 2000 banknote are added and are in circulation since 10th of
November 2016.
DEMONETIZATION IN INDIA
In India demonetization has happened thrice. The first was on the 12th of January
1946 (Saturday), second on 16th of January 1978 (Monday) and the third was on
8th of November 2016 (Tuesday). In the January of 1946, notes of denominations
1,000 and 10,000 rupees were withdrawn from circulation and new notes of
denominations 1,000, 5,000 and 10,000 rupees were introduced in 1954. Then
Janata Party coalition government again demonetised banknotes of denominations
1,000, 5,000 and 10,000 rupees on 16th of January 1978 with the notion of curbing
counterfeit currency and black money. The highest of all denominations ever
printed by the Reserve Bank of India was the Rs 10,000 note in 1938 and was
again in 1954. But these notes were demonetized in the January of 1946 and again
in the January of 1978, based on the RBI data. The first occurrence was in 1946
and the second in 1978 during which an ordinance was issued to phase out various
notes with denominations of Rs 1,000, Rs 5,000 and Rs 10,000 respectively. The
demonetization of denominations Rs. 500 and Rs. 1,000 banknotes was a policy
decision carried out by the Government of India on 8th of November 2016. In the
declaration, the use of denominations of all Rs. 500 and Rs. 1,000 banknotes of the
Mahatma Gandhi Series would be invalid after the midnight of the same day, and
was also announced that the new Rs. 500 and Rs. 2,000 banknotes of the Mahatma
Gandhi New Series will be issued in exchange for the above mentioned old
currency notes. The move by the government is defended as an attempt to
eliminate a reasonable volume of currency notes which is in the circulation
because of inflation.
3.4 Definition
DEFINITION of 'Demonetization'
Demonetization is the act of stripping a currency unit of its status as legal tender. It
occurs whenever there is a change of national currency: The current form or forms
of money is pulled from circulation and retired, often to be replaced with new
notes or coins. Sometimes, a country completely replaces the old currency with
new currency.
There are multiple reasons why nations demonetize their local units of currency:
to combat inflation
to combat corruption and crime (counterfeiting, tax evasion)
to discourage a cash-dependent economy
to facilitate trade
4.1 INDIA’S PAST EXPERIENCE WITH
DEMONETIZATION
India has carried out demonetization exercises twice before, in 1946 and 1978.
In Jan 1978 episode, currency worth INR 1.46 bn (1.7% of total notes in
circulation was demonetized. Of this INR 1.0 bn (or 68%) was tendered back.
In 1978 the value of demonetisation was very small (only 0.1% of GDP).
However, the 2016 demonetisation efforts covers 86% of the total currency in
circulation (11% of GDP).
In government securities
by
Banks.
May 1978)
The first principle is that remove the systemic pain that leads to creation of black
money in the first place. Blame lies with the tax department. Black money is
nothing but money generated in legitimate transactions which are hidden from
government so as to avoid paying the transaction cost (usually tax) in the
legitimate economy his is usually done by using physical cash. This cash thereafter
must be processed to convert into consumption or investment. Black economy
refers to various activities, transactions etc. that help process this physical cash,
create returns on this cash, facilitate consumption using this cash etc.
The second principle has two parts. First, not all cash transactions are necessarily
black money transaction. They become black money transactions only if they are
hidden from the legitimate economy. Thus, a shopkeeper who does not give receipt
but declares the sale (it’s only hypothetical) does not create black money.
Conversely, a shopkeeper who gives a receipt but discloses other receipt book to
the tax authorities (happens all the time) creates black money transaction. Second,
the black money must at some time or other be plugged into legitimate economy.
Thus, it cannot be done using user created currency that cannot be exchanged with
local currency. So it depends on legal tender. It means somewhere down the chain
there must exist a person for whom part of this black money is legal cash income
which he can use for his own consumption in legitimate channels. Usually, this is
the construction worker, or other poorest of the poor who will give certain services
and his income will remain under the government radar. It can also be illegal
traders in gold or diamonds etc. who can convert this into precious items that have
quasi legal tender status.
The third insight is that black economy is continuously fed by parts of white
economy that go underground. Quite a few people who do not want to promote
black money contribute to it. They are either coerced say developer forcing buyer
to pay him in cash or government officer seeking bribes in cash. Therefore,
preventing white money from becoming black the starting point. The
recommendations of Report titled Measures to tackle Black Money in India and
Black economy depends on black money financiers. These are money lenders
earning like 2% per month on their investments for financing the activities in black
money friendly sectors. Film financing, construction financing, retailers, dance
bars, alcohol, etc. These financiers also need enforcement mechanism to ensure
their money is safe. Naturally they ally with criminal elements. Al Capone, the
famous Chicago mobster, was previously an enforcer but later a financier.
Other Black Money Creators
There are other critical elements in black money chain or black economy. These
elements represent turning smaller amount of white money into black by
aggregation and misrepresentation. For example, take NGOs. Some of the NGOs
existing only on paper. Their model is thus. These NGOs collect legitimate
amounts from citizens and push it into causes like animal shelters, girl child,
medical aid to needy etc. The main problem is that the costs of these NGOs is
unreasonably high. They also commit fraud by misrepresenting number of animals
and kind of facilities etc. creating a source of black money for the promoters who
get salary and or benefits like cars and drivers from the NGOs. Cooperative banks
are another piece of the puzzle. These accept smaller deposits from individuals and
loan to founders and directors. The process is illegal and escapes the law only
because it is not regulated by the RBI but by Politicians who are themselves
directors in such institutes.
The model of trusts is a little different but they are as important elements in
processing black money as SMEs and others listed above. The trusts are both
receptacles and users of black money. They are not creators. Some allow devotees
to make small but numerous donations while spending substantial amounts on
expenditures related to their promoters. Others are created out of anonymous black
money donations with specific beneficiaries. Their nature makes them a hot-potato
issue where they seem to be untouchable by any government, religious entities
being protected by constitution.
So Will Demonetisation Eliminate Black Money? Not by itself. It is just one move
of one piece in the chess board of black money. To check-mate the black money
king, you have to win the board. There are various steps required as detailed above.
Government can play all these moves and still fail if they play improperly. All we
can say is that Government is playing well. But will it succeed? The efforts will
bring massive amounts of cash into the banking system – a benefit in itself. Once
the money is in the legitimate channels, it should be better utilized and revenue
will be generated from its use. If that is success enough then yes.
Short-term impact
In terms of the sectors in the economy, the sectors to be adversely affected are all
those sectors where demand is usually backed by cash, especially those not within
the organised retailing. For instance, transport services, kirana, fruits and
vegetables and all other perishables, would face compression in demand which is
backed by purchasing power. This in turn can have two effects: while it is expected
that supply exceeds demand, there would be a fall in prices, however, if supply too
gets curtailed for want of a medium of exchange, prices might, in fact, rise. Thus,
while generally people seem to expect prices to fall, it is quite possible that prices
would instead rise.
Alternatively, to keep the flows going, people might take recourse to credit - both
the retailers and other agents in the economy might make supplies on credit in the
hope that when the liquidity status is corrected, the payments can be realised. In
these cases, the price of commodities might rise instead of falling. In other words,
the impact of an incremental reduction in money supply where the demand and the
supply chain remain unaffected would be different from a case where there is a
drastic reduction in money supply and outputs might adjust rather than the
adjustment being in prices. In other words, the expectation that inflation would
decline might be belied.
Medium-term effects:
In the medium term, the effects would be related to the extent to which the
currency is not replaced within the economy. If the entire currency is replaced,
there would not be any major effects on the economy. However, it is to be
expected that the entire currency would not be replaced – to the extent currency is
extinguished and to the extent some of the currency remains as bank deposits, there
would be some impact on the economy. The first effect would be a compression of
the economy to the extent the extinguished currency was working as a medium of
exchange. The currency that is placed in the banks but not withdrawn, it is argued,
would generate an expansion in deposits in the economy. In the discussions on
demonetisation, there is a consistent reference to the resultant increase in credit
creation in the economy. Like Finance Minister Arun Jaitley says, “Bank deposits
will increase and they will have more capacity to support the economy.”
The total cumulative credit that can potentially be generated is defined in terms of
the reserve ratio.
In India, the cash reserve ratio is 4 per cent while there is a statutory liquidity ratio
of 22 per cent
In determining the credit creation, it is important to take into account only the CRR
and the additional credit creation can be 25 times the amount of money deposited
in the banks as a result of the proposed demonetisation.6 this amount however, will
be generated only if there exists an equivalent demand for credit in the economy.
There are a number of transition issues that need to be managed for this transition
to be effective:
The projections are done using the ratio for 2011-12 since in subsequent years the
ratio declined due to low off-take of credit in the economy.
Infrastructure Issues
There is need for a significant upgrade of the banking system as well as in the
telecom infrastructure that would provide the backbone for digital transactions. For
people to be able to transact at any time and place as well as for them to consider
it a reliable medium of exchange, it is important that not only the banking system
is upgraded to ensure that transactions can be completed without a hitch, but the
supporting infrastructure too is up to the mark. For instance, in many parts of the
economy, there is limited and intermittent supply of electricity as well as mobile
connectivity. In these areas, it would be difficult to expect people to shift to
electronic medium of exchange.
Apart from the technological issues, there is a behavioural change that is being
expected in people from using cash as a medium of exchange to using other cash
substitutes both for making payments and receiving payments. This transition
requires individuals to make two changes in their behaviour: one, agents need to
move from tangible means which can be seen and felt to forms which are less
tangible or not tangible, and second, they have to learn to rely on technologically
advanced tools to undertake regular day to day operations. The latter requires
agents to be educated to the extent of comprehending the content of transactions. If
this transition is not suitably managed, agents might be tempted to move to non-
official cash substitutes.
Accessibility in language
In addition to all of the above, most of the banks and the mobile instruments for
transaction are currently adapted to a single to two languages. If the bulk of the
population of this country needs to come on board, it might be important to make
these facilities available in a myriad of Indian languages to ensure that the user can
comprehend the transaction that they are entering into.
i. The banks too might have a transition issue to deal with. Banks would have
a model of the fraction of deposits that they can safely lend without an
excessive risk of withdrawal of the amount. This is important since, while
banks can borrow money from the call money market, the costs of such
borrowings can be large. These models, however, might need to be altered in
the new regime since the character of the new deposits that come into the
bank would be different from the pre-existing deposits. In the latter, while a
fraction of the deposits would be for transactional purposes – e.g. salary
earners – another fraction would be depositing only savings into the account.
By eliminating high value currency notes, these agents who were operating
through cash, would now have to move to non-cash instruments and hence,
the balances in their accounts would not be savings but transaction values
which will be retained in the account for shorter durations of time. The
banks therefore would need to re-model their decisions on how much of the
deposits can be lent out and for what duration. It is, for instance possible,
that a larger proportion of the deposits would be retained for short-term
lending and can even be dedicated to the call money market.
ii. Second, while 1/reserve ratio defines the potential maximum amount of
credit that can be generated in the economy, the actual credit generation
would be defined both by the demand for credit and the extent to which cash
intervenes in the functioning of the economy. For instance, if people who
receive credit from the bank make payments through cheques alone and they
in turn make payments through cheques, then the potential credit creation
can be realised. However, if on receipt of payment, the agent withdraws the
money to cash and makes payments, only a fraction of the credit/deposit will
return to the banking system. Thus, larger is the extent to which cash is used
as a means of transacting, smaller is the total credit that can be generated.
With a withdrawal of cash from circulation, the deposits will continue to
remain in the bank; it would merely shift from account to account or from
bank to bank. Thus, even on the earlier deposits, the amount of credit that
can be generated would be larger. This is another reason why the banks
would need to remodel their investment decisions corresponding to a given
level of deposits.
iii. A third issue that might arise as a transition issue is because of the mismatch
between people’s preferences for cash and the availability of cash. In the
interim, until people adjust to the use of non-cash instruments, there would
be an increased demand for the cash that is available and that might generate
a situation where the agents have to pay a premium to access legal tender. In
periods of scarcity of coins for instance, it is commonly known that people
pay a premium to get the change. While this can be considered a transition
issue, there are two different implications of such a development:
a. If the premium on cash is high, it would encourage both the shift to non-cash
instruments on one hand and to informal substitutes of cash on the other.
b. This might undermine the confidence that people have in the currency and
hence, encourage move to other currencies.
There is growing literature that points out to the possibility of changes in spending
behaviour as a result of moving to instruments other than cash. There are many
substitutes for cash in the modern economy ranging from cheques, debit cards, pre-
paid cards, credit cards and mobile wallets. When compared to cash, these
instruments differ in a number of key characteristics. Temporal separation or
degree of coupling is the extent to which a purchase and the payment for the
transaction from resources are separated in time. If the two are de-coupled, people
may not perceive a sense of separation from money at the time of incurring the
expenditure and hence may overspend.
The second characteristic is related to the pain of payment flowing from salience.
It is argued that people perceive the pain of payment depending on the tangibility
or salience of the outflow.
A third feature is the stringency of budget constraint – while cash limits one’s
ability to spend to the amount of cash in hand, a debit card expands it to the
balances available in the account and a credit card further relaxes it to include
future earnings as well
Payment Salience Salience Transparency Temporal Temporal
Mechanism Of Form of amount Separation Orientation
In a comparison of debit cards with cash, studies suggest that with the use of
debit cards, the level of consumption tends to be higher.
In a comparison of credit cards with cash, this effect is more pronounced.
Credit cards often are associated with more spending resulting in an increase
in debt as well
Further, spending with cards seems to encourage spending on non-essentials.
Apart from the transition issues faced by banks, in judging the impact on the
economy, it is important to differentiate between the two changes that the
demonetisation can bring about in money supply. The first change, i.e., cash being
extinguished, to the extent it was being used as medium of exchange, would result
in a compression in incomes, employment and consumption in the economy. On
the other hand, the effect of the second change, i.e., cash being only partially
replaced in the system would have the opposite effects of expansion in potential
credit creation. The potential credit creation would translate into actual credit
creation provided there is sufficient demand for credit. If the demand for credit in
the economy is large enough, the potential credit can be realised. Of the credit
created, other things remaining the same, it can be expected that at least a part of
the credit, will be for productive purposes. This would mean expansion in
investment in the economy and subsequently an increase in GDP and employment.
If there is increase in investment in the economy, the demand for capital goods
rises. If output can expand in this sector, there would be an expansion in the
income generation and in demand for goods and services. Sectors that are not
operating with excess capacity cannot meet the expanded demand with increased
output, leading to increase in prices. This would hold for agriculture as well as any
industry with long gestation lags to investment. In other words, in the short run
there is a possibility of increase in inflation.
With increase in GDP, since imports are supposed to be related to the size of the
economy, it is expected that imports will rise, but the same cannot be said about
exports. In other words, the balance of trade could worsen. This could result in
pressures on the rupee towards depreciation. Any increase in inflationary pressures
too could augment these pressures.
It should be kept in mind that credit is not the only constraint faced by the MSMEs.
There is a cost of compliance with regulation in the formal sector both of tax
legislation and other legislation which would increase the cost of operation. In the
absence of economies of scale, after incurring all these costs, some of the MSMEs
might not be viable in the new environment. In other words, the decision to move
from the informal sector to formal sector is a non-trivial decision for the units and
merely changing the access to credit might not be adequate to alter the status quo.
Under those circumstances, they might explore the use of alternative currencies as
a means for survival.
It is, however, not correct to assume that expansion in credit will definitely
materialise. In the last two years, the demand for credit in the economy has been
sluggish at best. In comparison to a credit deposit ratio of 1.53 in 2011-12, the
figures for 2014-15 were as low as 0.54. While there might be many factors that
contributed to this outcome, what is of consequence is that the demonetisation has
been introduced in this environment where demand for credit is rather low. A
compression in demand in the economy would further depress the sentiment
driving investments. In other words, demand for credit would continue to be low
and the potential credit will not be realised immediately.
The first consequence of this would be a fall in the interest rates in the economy
which could revive some of the sentiment since firms with outstanding debt would
have lower interest liabilities and hence, can see improved balance sheets.
The compression in demand would mean a decline in imports while exports might
not be adversely affected. This change in the balance of trade would induce an
appreciation of the currency. Along with lower interest rates, this could result in
inflow of investment by FIIs as well.
If the demand for credit is not very sensitive to interest rates – then the lower
interest rates would not bring in sufficient demand and banks would need to
explore alternative ways of placing the additional deposits available with them.
This could mean that banks take in more risky assets potentially opening up the
economy to more volatility and risks. This could include real estate, consumer
credit and consumer credit cards. The housing loan bubble of the US economy
might be one such example of lending to more risky projects, thereby bringing in
more volatility into the system.
Two more extreme possibilities that might follow are: a loss in the confidence of
the people in the official currency leading to bank run kind of situations if the
current description of waiting for long hours for withdrawing money persists and
the caps on withdrawal are not relaxed. Alternatively, they could shift to
alternatives to currency. Second, there could be social unrest if the compression in
incomes and consumption are severe and persistent.
The RBI earns seignior age through the printing of currency. In the
demonetisation, a part of the currency will be extinguished. For this part of the
currency, the RBI can print the notes given the assets on its books, but there would
be no takers. In other words, this part of the currency would be like new money
that can be introduced into the economy and hence yields seignior age to the RBI
once again when released into circulation. RBI, however, cannot lend this to the
government since that would involve additional liability build up on its balance
sheet. So, this currency can only be released when foreign exchange is being
converted to rupees for instance and not sterilised thereafter. At this point there
would accrue some dividends to the government as well. However, to the extent
the government and the RBI seek to move the economy towards digital
instruments, this option might not be exercised and the dividend might not accrue.
Impact through taxes: There are multiple channels through which taxes will be
affected:
November 8, when the whole world was waiting for the outcome of US
presidential elections, Prime Minister Narendra Modi came out with his master
stroke on corruption, counterfeit currency, terrorism and black money by
announcing demonetisation and ceasing Rs 500 and Rs. 1000 notes as a part of
legal tender in India.
The Reserve Bank of India manages currency in India and derives its role in
currency management on the basis of the Reserve Bank of India Act, 1934 and a
new redesigned series of Rs 500 banknote, in addition to a new denomination of Rs
2000 banknote is in circulation since November 10, 2016.The new redesigned
series is also expected to be introduced to the banknote denominations of Rs 1000,
Rs 100 and Rs 50 in the coming months.
The term demonetisation is not new to the Indian economy. The highest
denomination note ever printed by the Reserve Bank of India was the Rs 10,000
note in 1938 and again in 1954. But these notes were demonetised in January 1946
and again in January 1978, according to RBI data.
Since less than 5 percent of population in India had access to such notes and most
banks never had such currency notes, demonetisation did not have a big impact on
the country. The decision was taken to curb the illegal use of high denomination
currency which was used for corrupt deals in the country.
However, with the latest round of demonetisation, the common public and bankers
are undoubtedly facing hardship since more than 85 percent of currency in
circulation has been rendered illegal in one single stroke. Demonetisation is surely
hampering the current economy and will continue to do so in the near term and will
also impact India’s growth for the coming two quarters but will have positive long
lasting effects. The question that arises is why demonetisation was required at this
point of time. There are certain pros and cons of demonetisation.
Pros
One of the biggest benefits of this move is that it is going to drastically affect the
corrupt practices. People who are holding black money in cash will not be able to
exchange much as they would be in a fear of getting penalised and prosecuted by
the authorities. Enemies of the country which are involved in counterfeit currency
and terrorism will not be able to continue it further for quite some time at least.
The smuggling of arms and dealing with the terrorist will not sustain further as all
of the money will be on record now. Secondly, the banking system will improve as
it will slowly head towards a cashless society. Cashless society will increase credit
access and financial inclusion. The existing white money of people will be known
to the government and it will remain with banks so that it can be put on loan, and
interest can be generated from it (though interest rates would fall) with a
corresponding fall in Inflation.
Further Banking System will get a boost, as more than Rs 7-8 lakh crore base
money (new legal money) will enter the system. However, it needs to be seen how
much money actually remains in the system, once the cash withdrawal limits are
eased.
Thirdly, it will reduce the risk and cost of cash handling as soft money is safer than
hard money. It will also reduce government liability. Since every note is a liability
for the government, the old currency will become worthless for those people, who
choose not to disclose their income. Thus, this will extinguish government's
liability to that extent. It is expected approximately Rs 5 lakh core may come to the
government in the form of extinguished RBI liability, taxes and penalties. This
amount is enough to take care of India's entire fiscal deficit for one year or more.
It will also reduce tax avoidance. Whatever money will be deposited or exchanged,
authorities will keep a track of it and they will be extra cautious in this period.
Dealing in this period in sectors like jewellery and real estate will be on radar and
those entering into Loan transactions may also undergo tax scrutiny. Search and
Seizure activities of the IT Department will also rise to curb such malpractices.
Limits have already been prescribed for reporting to the IT Department those bank
accounts in which excess cash deposits are being made in this 50-day window (Rs
2.5 lakh in case of individuals and Rs 12.5 lakh in case of firms).
Importantly, in the longer run, tax and interest rates on loans are expected to come
down as higher income tax collections arising from better compliance would offer
scope to reduce rates over the long term. This, in turn, will drive up disposable
income. This can give a positive impact on consumption demand in long term.
Cons
Secondly, there will be added replacement costs of currency. We cannot ignore the
increased cost of operating ATMs need to be refilled more often and also it will be
a huge burden on banks. Initially, it is very difficult to create a cashless society as
more than 50 percent of Indian population is not well versed with card
transactions. Also for these initial months, it will be very difficult to make cash
transactions of a higher amount. But the government is taking steps to improve
liquidity into the system and reduce inconvenience as much as possible.
India is certainly going to experience "Acche Din" in Modi's regime. The decision
of this surgical strike on black money was not taken in a day or two. Rome was not
built in a day and similarly, this plan is the result of Prime Minister's meticulous
planning and never ending fight against corruption. As a result, he has successfully
made the right stroke at the right time.
Further, the penal provisions are hefty enough to ensure that corrupt practices will
find it hard to take roots again. Despite certain short term troubles, demonetization
is certainly going to give a boost to the Indian economy in the long run. As of now,
all of us should stand and support this bold move of our Prime Minister and help
those needy, around us.
Expected impact on fake currency
A study by the National Investigation Agency and the Indian Statistical Institute, in
2016, estimated that fake Indian currency notes in circulation have a face value of
Rs. 400 core. This is an incidence of fake currency of 0.022%. The scale of
counterfeiting of the Indian rupee is not out of line with what is seen in other
countries, and the procedures adopted worldwide to address this include
investigative actions against counterfeiters, phased replacement of old series of
notes with new notes that have better security features, etc. Demonetization is
generally not seen as a tool for dealing with counterfeiting. We must also not
forget that the counterfeiters will now get to work on the new 500/2000 rupee
notes, while India will likely never do a demonetization again.
The analysis presented in the finance ministry’s White Paper on Black Money,
2012, shows (on page 47) that, on an average, the amount of cash seized during
raids by income tax authorities is 4.88% of total undisclosed income admitted in
those cases. This data is from more than 23,000 warrants executed. Even if this
decision inflicted a 100% loss upon holders of unaccounted cash, this would imply
a loss of only 4.88% of their total unaccounted wealth, which is not much of a
shock for those with such wealth. If, as is more likely, the demonetization has
imposed a 40% loss upon holders of unaccounted wealth (who suffer a 40%
discount when laundering their money), this implies a loss of just about 2% of
unaccounted wealth.
Expected costs
Cash is a store of value (white or black), but it is also a medium of exchange. Most
people in India only transact with cash. More than 90% of shops accept only cash
or very short-term credit. Large numbers of laborers and small value suppliers are
paid in cash. While these facts may change over time, they mean that this sudden
ban may be leading to disruptions in consumption and production. Compared to the
10,000 yen note ($137 in purchasing power parity), the 1000 Swiss franc note
($775), the USD 100 note, or the 500 euro ($530) note, the Rs. 1000 ($31 in
purchasing power parity) and Rs 500 ($15.5) are practical notes that are used for
daily transactions. Hence, demonetization of these notes is a large adverse
monetary shock – perhaps the largest ever such shock in world history. The
constraints of ATM recalibration and currency printing are leading to a long
transition period. Even ensuring 50% re-monetization in cash form – about Rs. 7.5
lakh core – by December-end appears hard. The Centre for Monitoring of Indian
Economy has estimated that a few elements of the first-round impact give a
reduction of GDP of around Rs 1.3 lakh core; the total impact will be higher owing
to the multiplier effect, the hysteresis associated with the monetary shock, the
impact upon expectations, etc.
While there is much talk about the GDP impact of this decision, a unique feature of
this episode is that there may considerable other costs that fall disproportionately
upon the poor. The rich have access to electronic payments, employees who will
stand in queues to obtain cash, and savings that are used to cope with a decline in
income. The poor lack all these. If a poor person suffers an income shock, or is not
able to get medical treatment, the consequences are enormous for the individual,
but the GDP impact may be negligible. In terms of welfare implications, these
costs matter a lot more than the impact on GDP.
The benefits are primarily in the form of losses inflicted upon those with black
money, while costs are imposed on legitimate economic and social activities.
Ordinary people, going about their lives, have suddenly been asked to bear a
burden associated with the project of imposing costs upon people who have
unaccounted wealth. Some of the costs are incurred by poor people, whose welfare
loss might be much more for a given level of rupee cost incurred.
Given this difference in the nature and incidence of benefits and costs, each rupee
of cost should be given a much higher weight than each rupee of benefit.
It seems, thus, that the economic costs of this decision are likely to outweigh its
economic benefits.Some have compared this decision with a surgical strike, but it
is more like a nuclear strike. The nuclear option has been exercised before
exhausting other options. Although measures to help people disclose their
undisclosed incomes have concluded, the efforts to directly or
indirectly curb illegality have barely begun. This raises concerns about the wisdom
of using this lever of demonetization.
What the media says and doesn’t say
The mainstream media narrative around the decision is not as pessimistic as the
analysis presented above. There is a disconnect between the mainstream narrative
and the facts emanating from the ground
Two ideas have been offered in the claim that the adverse impact upon the poor
will be small:
The financial lives of poor households are very different from those of the middle
class and the rich in one crucial aspect – the intensity and frequency of financial
transactions involving cash. The ratio of financial turnover to assets held, during a
given period, is much higher for poor households. Financial turnover is the total
value of all financial transactions, i.e. putting money in or pulling money out from
any informal or formal financial instrument.
Think of a middle class household with one salaried person earning Rs 600,000 a
year, with total financial investments worth Rs 10,00,000. From the bank account,
money is withdrawn and spent, or drawn down through card/online payments, or
transferred into an investment instrument. If this person has a credit card, each
purchase on the card would create two financial transactions of equal value –
drawing credit, and repaying credit. Other than this, there may not be much “push
and pull” in the person’s financial life; only simple drawing down or investing up.
She may occasionally take loans or switch across investment instruments.
Financial turnover during a year is likely to be much lower than the total value of
the financial assets owned. The cash portion of the transaction value may be
smaller yet.
Why Claims Backing Demonetization Are Faulty
Demonetization may significantly disturb the markets, which may adversely affect
economic activity and employment. Credit: Reuters
Prime Minister Narendra Modi’s 50-day deadline for a return to normalcy post
demonetization is over and the move has proved to be a failure. But despite clear
evidence of its failure, the supporters of demonetization still consider it to be
successful, making several vague claims in its defense. One of the commonly made
claims is that demonetization will clean up the economic system. Another is that of
employment generation.
It has been argued that India had jobless growth because a large share of the
transactions was not accounted for. Some point out that high denomination notes
were hurting the economy. The problem with such claims is that they are often
accepted as the truth simply because they come from a renowned person or a
minister. Even if these ardent supporters accept failure, it is attributed to the faulty
implementation of demonetization and not the policy per se.
To understand the problem with this claim, one has to first understand the way in
which black money affects the economy. There are two major sources of black
money – corruption and tax avoidance. Corruption affects economic activity by
increasing the cost of doing business. For example, if the cost of producing a
commodity is Rs 100 and Rs 20 has to be paid to a government official as a bribe,
then the actual cost of production is Rs 120. The higher cost of production has a
negative effect on economic activities.
The second source – tax avoidance – does not affect economic activity directly.
Instead, its effect is through a higher burden of tax on a small number of
businesses. The higher burden of taxes affects the growth of these businesses,
whereas the businesses that can avoid taxes enjoy higher growth.
Three negative effects of tax avoidance may be identified. First, it leads to higher
corruption and other wasteful activities in the economy. Second, it prevents
businesses from shifting to more efficient production methods, and third, it
interferes with the people’s consumption choices by changing the relative cost of
commodities.
Even though corruption and tax avoidance hurt economic activity, the damage
cannot be undone by recovering the black money that has been generated earlier.
The government can only avoid future damage by preventing these activities.
For instance, if a firm had produced less in a previous year due to corruption, then
recovering the bribed money from the corrupt official is not going to increase the
production of that year. Similarly, the higher burden on tax-paying businesses in
the past is not going to vanish just because the government had recovered some
money today. It is because corrupt actions and not the previously created black
money are responsible for the damage. The growth rate is hurt by the present
creation of black money and not due to the existence of black money in the system.
Ironically, this claim is made by some of the supporters of market economy. The
bizarre thing about this claim is that demonetization is against the basic philosophy
of a market economy. Market economy requires inaction of the government. The
believers in market economy ask for less interference. They believe that the
markets are inherently good and it is the interference of the government that
disrupts the working of markets and creates inefficiency.
It is the demand and supply forces that lead to market adjustment. In fact, the
working of a market is not affected by the existence of black money. The
advocates of market point to corruption and tax evasion as the outcomes of
government interference and higher tax rate, thereby leaving no logical connection
between demonetization and market correction.
As a result, 30-40% of the black money kept in the form of cash will go to these
people. These unintended beneficiaries of demonetization are likely to put this
money into different use than the original hoarders of the money. This new use
may require the reallocation of resources. For instance, if those who lose the cash
were not using the money, whereas the new recipients start spending it, then its
effect will have the effect similar to printing new currency.
If it is the opposite, then it will lower the money supply in the economy. If the
original owners were the producers of houses and the new owners are buyers, then
production of houses will decline, whereas the demand will increase. There are a
number of other possibilities. Most of these possibilities will require the markets to
readjust.
If the estimates of black money are true, then demonetization may significantly
disturb the markets, which may adversely affect economic activity and
employment. This problem would have existed even if the government were
successful in destroying all of the black currency. In fact, the situation might have
been worse as the whole money – instead of 30-40% – would have been put to a
different use.
Another problem with this argument is that it considers the value of currency to be
fixed. High denomination notes are only problematic if they have high purchasing
power. In reality, the value of currency note does not remain the same as its
purchasing power declines with inflation.
The consumer price index of agricultural labor shows an increase in prices of about
47.76 times between 1960-1961 and 2015-16, i.e. a bundle of goods that used to
cost Rs 100 in 1960-61, costs Rs 4,776 in 2015-16.
In other words, there was about 48 times decline in the value of a currency note
between 1960-61 and 2015-16. It means that the purchasing power of an Rs 1000
note in 2015-16 was almost equal to the value of a Rs 20 note in 1960-61.
Therefore, Rs 500 and Rs 1000 notes in 2016 were no more ‘high denomination’
than the Rs 10 and Rs 20 notes in 1960-61.
The low value of Rs 500 and Rs 1000 notes is also evident from the fact that,
unlike in the past, the high denomination currency was widely used by common
people before demonetization.
Moreover, the existence of black economy does not need the existence of high
denomination notes, as the corrupt can accumulate wealth in other forms. For
example, the corrupt can start using gold and silver in their illicit transactions.
Given the lower value of demonetized notes when compared to the same
denomination notes of the past and possibility of using other methods of
accumulating wealth, the claim that high denomination currency was hurting the
economy is not based on any sound reasoning.
Claim: Economy will bounce back once the currency notes are
replaced
I expect that most of you will by now have read a fair bit about the (to my mind)
fabulous living monetary experiment that is India. Obviously, I feel sorry for
people who have been (to put it mildly) inconvenienced by the chaos caused by the
removal of 85% of the cash “in circulation” in the country, but as a student of
monetary history and the interaction between technology and economics, it is
absolutely fascinating to look at what is happening.
Indian Prime Minister Narendra Modi has announced that the existing 500 and
1,000 rupee banknotes will be withdrawn from the financial system overnight. The
surprise move is part of a crackdown on corruption and illegal cash holdings, he
said in a nationwide address on television.
From India scraps 500 and 1,000 rupee bank notes overnight – BBC News
I saw some television reports of aggrieved and panicked Indians who were unable
to get any cash and since much of the economy is cash-based, worrying about a
slowdown in economic activity. It’s a bit of shock to go to the bank and discover it
is closed. When the banks re-opened, it was with new money. Or at least it would
have been with new money, had replacement been produced and distributed
beforehand.
On November 8 evening, Reserve Bank of India governor Urijit Patel and senior
government officials unveiled the new currency note of Rs 2000 and redesigned Rs
500 note.
From New Rs 2000 note to be introduced in India after banning old Rs 500 & 1000
notes: Pictures of 8 best looking currency notes across the globe – India.com
The result was pandemonium. People went to ATMs to try to obtain new bills only
find that there were none to be had. Rich people started paying poor people to
stand in line for them to get money. I even saw a photo of people praying to a
garlanded ATM! India is a big country and the ATM vendors had no more warning
of the change than anyone else, so as you can imagine the planning and logistics
were complex. The ATM operators were as non-pulsed as the general public by the
sudden change.
From Just 35,000 personnel to replenish ₹16 lakh crore in ATMs | business-
news | Hindustan Times
The net result of all of this was that the country ran out of money. Literally. There
was no money available for commercial transactions. So to Indians, it really was a
big deal and a major disruption.
So why was this done? There were two explicit reasons given for the
demonetisation. One was that it was an attack on terrorist funding, and the second
was that it was an attack on the black economy. I don’t know enough about
terrorist financing in India to comment on the efficacy of the move, but it seemed
to target counterfeiting operations in Pakistan.
From Taking out Pakistan’s terror mints: The Big Story – India Today
21112016
As for the black economy, there is no doubt that the move has had, and will have,
an impact. There was an awful lot of money sloshing around outside of the banking
system, and as far as I understand, there was rampant tax evasion amongst the
more well-off amongst the population. Having spoken to a couple of people
recently returned from India, I got the impression that members of the public were
comfortable that the disruption, bad though it was, was a price worth paying. And
there is no doubt that the move shifted many transactions on the record
immediately.
The government’s plan was that people would bring their cash to the bank, declare
it, pay tax on it and then either get new cash in return or actually start using bank
accounts (a great many of which are dormant). And, indeed, this is what seems to
have happened, with the cash being returned in amounts greatly exceeding the
government’s calculations. By the end of the year, almost all of the notes had been
deposited.
Banks have received 14.97 trillion rupees ($220 billion) as of Dec. 30, the
deadline for handing in the old bank notes, the people said, asking not to be
identified citing rules for speaking with the media. The government had initially
estimated about 5 trillion rupees of the 15.4 trillion rupees rendered worthless by
the sudden move on Nov. 9 to remain undeclared
That seems a reasonable deal. Pay tax to the government and potentially have to
give up the rest of the cash because of anti-corruption investigations … or pay tax
to the jeweler and mum’s the word. Since India has a long tradition of using gold
jewelry as a store of value, this seems unsurprising in retrospect. It led to another
crackdown on those who decided to convert their black money into black (but still
quite liquid) gold.
This move will halt such sales of gold at a huge premium against old currency
notes, which jewellers were doing till the Income Tax (I-T) department raided
them across the country on Friday and sent around 600 notices to jewellers asking
the details of daily sales from November 7 to 10. The I -T department, in its
notices, also asked for CCTV footages, especially of cameras near cash counters,
to seek date-wise information and to check if PAN numbers or ID proofs were
collected from customers.
Anyway, the upshot of all of this was that cash vanished from circulation without a
viable alternative in place. What kind of alternative might there has been? Well,
the answer is obvious. India really should have a widespread, vibrant and effective
mobile payment infrastructure, but it has been slow to develop. I wrote about this a
few years ago, noting that it was the regulatory environment that was holding back
the evolution of the sector (the Reserve Bank of India’s “calibrated approach” to
mobile payments). As the figures from Kenya that I recently posted show, it is
possible to use mobile phones as an alternative to cash.
Look at Kenya, where there are now more than 33 million mobile money users and
174,000 mobile agent locations. The most recent figures from the Central Bank of
Kenya (CBA) show an astonishing trend. From February 2013 until September
2016, the number of monthly M-PESA transactions almost tripled, going from 53
million to 131 million, while the number of card transactions fell from 34 million
down to 18 million.
In fact, bit coin volume on India exchanges doubled in the couple of weeks
following the announcement but then fell back again at the end of the year. I think
it highly unlikely that bit coin will step in to fill the gap left by the removal of the
highest value banknotes. It looks to me that a more widely-used alternative to cash
will be… nothing. In the cities, the merchants are getting payment terminals or
mobile phone alternatives, but outside the cities, people could easily get by for
some time without a circulating means of exchange.
This is not wild prediction. I have previously posted about the famous case study
of the Irish bank strikes that demonetized the Emerald Isle in the 1960s and 1970s.
Subsequent economic analysis showed that the absence of money had surprisingly
little impact on the economy! People just began to write cheques or IOUs and these
debt instruments began to circulate.
Murphy points out that one of the key reasons why a “personalised credit system”
could substitute for cash was the local nature of the circulation — which… was
centred on pubs — so that the credit risk was minimised.
In summary Ireland was a more rural economy in those days so life continued in a
reputation-based transaction economy. Well, guess what: the same thing is
happening in India.
However being a very close knit society, local people count on each other so they
are able to buy the essential commodities from the shops in good faith, the
payment of which they would make later on after having money. So this way, they
are not feeling panicky like rest of the country
From Here, banks are giving only 10 rupee coins – Times of India
One of the reasons for this development lies in the increasingly prominent role
anti-corruption plays within electoral politics in India. Returning “black money”
from foreign tax havens and distributing it to the poor was one the key promises
made in Modi's successful 2014 election campaign; demonetization, thus, can be
seen as more than economic policy but rather as a political tool. With previous
schemes, such as a 2016 amnesty offer for tax evaders, being less successful than
anticipated, Modi and his party have a strong impetus to portray demonetization as
a show of their commitment to anti-corruption. In order to do so, the government
had to establish in the public mind a strong relationship between cash and
corruption. This, however, may have skewed the public understanding of anti-
bribery and corruption frameworks, downplaying not only other means of
acquiring and storing income generated from corrupt activities but also presenting
corruption as a conflict between rich hoarders of cash and the marginalized poor.
The Prime Minister's attempts to position himself as a “Robin Hood”-type
character whose focus is to take illicit cash from the rich and redistribute it among
the poor risks reducing ABC initiatives to a precarious binary of “us-vs-them”,
which in turn may undermine more serious discussions on the role of policy, the
law and institutions.
Demonetization has changed the tone and pace at which corruption is spoken about
in India. Crucial for the long-term success of ABC policy-making, however, will
be in how far the policy has set the agenda on the relationship between cash and
corruption and the role of institutions and the private sector
8. Bibliography
1. https://en.wikipedia.org/wiki/Indian_500_and_1000_rupee_note_demonetisation
2. http://www.gpedia.com/en/gpedia/Indian_500_and_1000_rupee_note_demonetisation
3. http://wikivisually.com/wiki/Narendra_Modi%E2%80%99s_demonetisation_policy
4. https://www.scribd.com/document/333281229/demonetisation
5. https://infogalactic.com/info/Indian_500_and_1000_rupee_note_demonetisation
6. http://jaipuria-jaipur.forumotion.org/t33p75-do-good-intentions-matter-if-they-lead-tobad-
outcomes
7. http://profit.ndtv.com/news/economy/article-deposits-before-april-1-can-be-disclosedunder-
pradhan-mantri-garib-kalyan-yojana-1638594
8. http://www.trendingnews.co.in/search/pradhan-mantri-garib-kalyan-yojan/2
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economy-rs-500-100-2000-pm-narendra-modi-currency-bank-notes
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26c3c45ec5d%2FDemonetisation%20graph.JPG?auto=format&q=60&w=976&fm=pjpg
13. https://www.rbi.org.in/Scripts/FAQView.aspx?Id=119.