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Demonetisation: A Debate Without Substance

March 13, 2017

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Here’s a little conundrum.

Suppose I want to pay my tailor £500 (guineas if he is Saville Row); and I write him a cheque and post it to him before learning that the postbox was forcibly opened by a thief and the contents of the box stolen; I don’t want to take any chances, of course, so I stop the cheque and I go to the tailor in person, paying him his pounds (or guineas) in cash.  And this is the question: with the cheque now stolen and stopped, but still in circulation, who actually loses out because I won’t honour my promise to pay assuming the cheque is eventually presented to my bank? Not me of course; and certainly not the tailor (who has been paid), but quite possibly the thief (although, presumably, he won’t be in any position to complain).

And you might think that would all be simple enough, but when the same situation is translated into macroeconomic terms it has been causing no end of heartburn for economists.

Because on 8th November last year, the Indian Government removed from circulation two denominations of banknotes that together made up 86% of all of the rupees previously in circulation; it is a policy known as Demonetisation. And to make the policy work, the Central Reserve Bank of India was required to dishonor its promise to make payment on the notes that had been withdrawn from circulation. Just like I might stop the cheque to my tailor.


In a slightly arch, if a rather unworldy The Economist Magazine last month portrayed this decision by the Central Bank of India, the decision to dishonor the withdrawn notes as little short of a scandalous breach of promise; having issued the notes in the first place, the Central Bank should honor them and its reputation would be seriously harmed if it failed to do so.


But why should that be the case? The old (withdrawn) notes are not simply being liquidated into the ether by demonetization; holders of withdrawn currency were given until 30th December last year to exchange their holdings of old notes for new, higher denomination currency and the Central Bank will certainly be honouring it’s promise to pay on those notes. And, of course, nobody spoke of the Bank of England defaulting on its promise to meet a call on pre-decimal (withdrawn) currency when new, decimal notes were issued in the United Kingdom in 1971; and nobody accused the Bundesbank of reneging on its payment commitment when Deutschmarks were withdrawn and exchanged for Euros in 2002; not least because neither it nor the Bank of England was doing anything of the kind and neither, for that matter, is the Central Reserve Bank in India.


So why should India be any different? It all sounds more than a little parochial.


After all, ask yourself who loses by demonetization. Only the black economy (the exact analogue of the thief who steals my tailor’s cheque); only those, in short, who are holding a stock of withdrawn denomination currency, which they are unable to take to a bank to exchange because they cannot or will not explain how they got it in the first place; and that, of course, is precisely what demonetisation is designed to achieve: to take the black market economy in India by the throat, stop it in its tracks and pave the way for a more invigorated, open economy.


In announcing demonetisation last November, Prime Minister Modi explained that a key objective of the policy was to combat corruption and to render more accountable to the Indian Exchequer what was perceived to be a hidden stockpile of untaxed cash.  Who exactly is going to disagree with that? Although, oddly, the latest reports suggest that some 15 trillion rupees of the 15.4 trillion taken out of circulation are now accounted for. So perhaps the black market in India wasn’t quite as pervasive as had previously been thought, and that has to be a good thing too.


But aside from these essentially negative policy objectives, there are also at least three beneficial effects of demonetisation:


  • First, Banks across India will now have additional stockpiles of cash available to them as a result of recently converted currency deposits and should, therefore, be more willing to lend it out to businesses looking for additional credit; and that ought to act as a stimulus to further growth across the economy as a whole. The bigger banks on the subcontinent cut lending rates last month which may suggest demonetisation is already having an impact on that front;


  • Secondly, demonetisation should mark the beginning of the end of the exclusive cash culture; signalling a progressive, irreversible move away from a rigid, cash-based economy. Prime Minister Modi promoted the idea of a cashless or (as he quaintly put it) “less cash” India, as being one of the driving forces behind demonetisation and sure enough there has been a marked trend over recent months towards increased Electronic Fund TransfersEFT transactions. The Indian economy can only be stronger because of it;
  • Thirdly, with the withdrawn denominations now effectively worthless, the Indian government can appropriate the proceeds of the demonetisation program without affecting its net balance on the Central Reserve’s books. On a straight rupee exchange basis (old for new) the amount remitted to Central Funds by the Reserve Bank after demonetisation could be as much as 0.3% of Indian GDP and that would be just the kind of added stimulus that an already resurgent public infrastructure program is looking for.


So it may, on balance, be wise to treat the naysayers of India’s demonetisation policy with more than a little healthy skepticism. And especially so in the light of last year’s fourth quarter figures for economic growth on the subcontinent which were released last month and which recorded a healthy 7% growth in GDP; and that, we should bear in mind, is not only in line with annual growth figures for the Indian economy for the period down to the fourth quarter, but it also coincides precisely with the period when the demonetisation program was operating at its fullest pitch.  Far from hurting the Indian economy, it seems to have helped it.


So who loses?


Red Ribbon CEO, Suchit Punnose said:

Demonetisation has certainly proved to be one of the most controversial political programs of recent years, and especially so as it involves one of the World’s leading Economies; but in my opinion, this has been both a brave and a necessary policy for the Indian Government to embark on. As the article points out, the time has come for India to take what remains of its black money economy by the throat, and to lay a solid and sure basis for the wider economy on the subcontinent going forward.

Prime Minister Modi’s Government is to be commended for accepting that challenge. India can only be stronger for it and this is certainly not the time for half-measures or a lack of resolution. India is now the fifth biggest economy in the world and the fastest growing large economy globally. It is time for it to take its place at the economic top table and Demonetisation has been a necessary part of that process.

And far from acting as a fetter on growth, I am very pleased to see that in the fourth quarter of last year India’s GDP growth figures were as strong as the first three-quarters of the year had been. Demonetisation certainly seems to have acted as a stimulus for growth, rather than the fetter the naysayers would have had us believe.

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