India runs on cash and that comes with its own set of problems. The most pronounced among them is the black money that the cash economy generates, which fuels the country’s shadow economy used to evade taxes and scrutiny.
It is that shadow economy that the government is targeting through its decision to withdraw high denomination currency notes of Rs 500 and Rs 1000.
Prime Minister Narendra Modi, while announcing the decision on Tuesday, made it clear that the government wants to clamp down on the black economy. Taking Rs 500 and Rs 1000 notes out of circulation is one step in a series of measures taken, said Modi while highlighting that those with unaccounted money were given the opportunity to disclose these funds under the recently concluded Income Disclosure Scheme. Those who didn’t, will pay the price.
The magnitude of cash in circulation is directly linked to the level of corruption. Inflation becomes worse through the deployment of cash earned in corrupt ways. The poor have to bear the brunt of this. It has a direct effect on the purchasing power of the poor and the middle class...High circulation of cash also strengthens the hawala trade which is directly connected to black money and illegal trade in weapons...To break the grip of corruption and black money, we have decided that the five hundred rupee and thousand rupee currency notes presently in use will no longer be legal tender from midnight tonight, that is 8th November 2016.Narendra Modi, Prime Minister of India
How Big Is India’s Shadow Economy?
India has among the highest usage of cash across global economies. According to a 2015 report from PwC, 98 percent of all transactions by volume happen in cash. 68 percent of the total value of transactions are conducted in cash.
The most recent estimate of the shadow economy, that is a byproduct of this cash economy, came from consulting firm McKinsey & Company in 2013. Based on that analysis, India’s shadow economy is as large as 26 percent of the country’s gross domestic product.
This implies that almost one fourth of the Indian economy goes untaxed and unaccounted. Noting that India also has a very high proportion of cash-based transactions, McKinsey in its report said that “high cash usage perpetuates a shadow economy and hinders the evolution of a digital economy.”
“A prevalence of cash often allows an “informal” or “shadow” economy—one that is not taxed, monitored by government, or included in the GDP—to grow or dominate. International comparisons show a clear correlation between cash usage in the economy and the size of the shadow economy,” said the report.
While the government’s move to discontinue high denomination notes is expected to make it difficult for hoarders to amass large sums of wealth, the suddenness of the move is likely to impact businesses of all sizes in the short term, experts said.
“Though clarity is unfolding on this, commodity transactions and general cash market transactions are likely to feel an immediate impact. Unorganised sector proceedings including small trade market activities will remain volatile in the short term,” Anis Chakravarty, Lead Economist, Deloitte told BloombergQuint.
“People are likely to only shop for necessities and hold back on other cash purchases till the situation improves or eases so there will be a big impact on the erstwhile informal economy which was running on cash.”
Chakravarty added that luxury commodities like gems and jewellery, automobiles and high-end branded products will see a drop in sales. Some of these products and sectors are places where black money was used.
Will This Reduce Cash Transactions?
The government claims that the move will ensure that more transactions move from cash to digital modes and come under the purview of tax authorities in the long term.
India has a high rate of circulation of liquid currency in the economy which makes up 12.2 percent of the gross domestic product in India, higher than Russia’s 11.9 percent and China’s 4.8 percent, according to a research paper published by Instituto Brasileiro de Geografia e Estatística in 2013. The agency is a government body responsible for statistical information in Brazil and studied the use of cash across key emerging economies.
The high value of cash transactions means significant costs for handling and maintaining cash for banks, said McKinsey in the report quoted above.
“The operational cost of cash includes the direct expense of producing, collecting, storing and safeguarding it; counterfeiting costs; and the time spent processing cash payments in merchant tills, business back offices, government agencies and banks. While banks and merchants directly incur most of these costs, the economy bears them indirectly in the form of fees, foregone interest, higher consumption prices and reduced corporate dividends.”McKinsey Report 2013
A Citi Research note on Wednesday said that most of the currency in circulation in the economy is made up of Rs 500 and Rs 1000 notes which are now being discontinued.
RBI data suggests that the proportion of Rs 500 and 1000 notes was 86.4 percent of total value of notes in circulation on March 31, 2016, amounting to Rs 14 lakh crore. The growth rates in these notes was 76 percent and 109 percent respectively in the last 5 years versus the 40 percent increase in overall currency, the note said.
Citi Research said that the process of exchange, which will take place over a 50 day period, could result in temporary inconvenience but the move is a “decisive blow” to the black economy.
It sends a strong message about the government’s anti-corruption drive and would improve India’s reformist stance. It also provides a boost to government’s financial inclusion drive pushing more households towards efficient banking and payment infrastructure.Citi Research
Body Blow To Fake Currency Rackets
The move will also reduce the flow of fake currency in Indian markets as data shows that most of the counterfeit currency in circulation exists in high-denomination notes of Rs 500 and Rs 1000.
According to the Reserve Bank of India’s annual report published this year, more than 2.61 lakh counterfeit notes in the denomination of Rs 500 were detected by banks in the year 2015-2016 while another 1.43 lakh fake notes of Rs 1000 were detected. By value, counterfeit notes of Rs 500 and Rs 1000 accounted for more than 92% of all the fake currency detected by banks across the country.
What Could Be The Collateral Damage?
To be sure, there will be collateral damage in the near term even if the long term impact of the government’s decision is positive.
“If money supply declines temporarily because of these measures, then assuming no immediate change in velocity of circulation, we could either see some deflationary tendencies or lowering of real demand (economic activity),” said Citi Research while commenting on the broad
Radhika Pandey, an economist with the National Institute of Public Finance and Policy said that a “coercive move” like this may not yield desired results.
“There are significant volumes of genuine businesses in small towns and cities that still run on cash. The cost upon them will be enormous. Further, the Government has banned Rs 1000 notes and Rs 500 notes but planning to introduce Rs 2000 notes. They are bringing notes in an even higher denomination notes,” Pandey said while speaking to BloombergQuint.
Calling this measure extreme, Pandey said all business which run on cash will now have to realign their payment cycles and cash flow schedules.
“It will be a short term disruption to the businesses. They will have to reschedule the payments-cycle. The B2B business will need to be adjusted. The institutional mechanism of putting in place measures to move towards a cashless economy should have been put in place first before adopting this extreme measure,” Pandey said.