Prime Minister Narendra Modi's surprise "surgical strike" of demonetising Rs 500 and Rs 1,000 notes is perhaps a mother of all money policies that a central bank can deliver.
The move will not just shrink money in circulation and tame inflation but also pull out all the black money stacked in privy cabinets and render all those fake notes printed in Pakistan as useless paper pieces.
Finance Minister Arun Jaitley asserted that the demonetisation will be a big step to move towards a “cashless” economy.
The immediate inconvenience caused to household is insurmountable—many people “bought" Rs 100 notes at a hefty premium in exchange of Rs 500 and Rs 1,000 notes. Many household have been forced to hold back day to day transaction with whatever less denomination notes were left. Many people in the hinterland are in hardship as they have to walk miles just to get a Rs 500 rupee note changed.
Politicians are quick to cash in on the plight of the common man to foment sentiments against Modi even though the bold step is for their betterment.
Congress leader and former Finance Minister P Chidambaram have volleyed a number of questions on the Modi government. One, will the present cash to GDP Ratio of 12 per cent come down? Two, how is demonetisation of high value notes served if a new & higher value note is introduced? Three, if new income is unaccounted will that not be hidden in the Rs 2000 notes? Four, how will this move help preventing of black money? Five, if the Rs 500 note is to be replaced by a new Rs 500 note, then what purpose would this exercise have served?
COUNTERING TERRORISM VIA MONETARY METHODS
Modi's men at the Finance Ministry will not have all the answers as there is no estimate of how much of fake notes are in circulation right now--the only estimate available is the one that has come in the banking channel, got detected and seized.
However, it is a fact that some outfits based in Pakistan are printing counterfeit Indian currency and that is changing hands. Most of these are of Rs 500 and Rs 1,000 denominations.
The counterfeit notes are exchanged for genuine notes and used for funding terrorism. This has to stop. The only way to do it is bring all the old notes in the banking system--the counterfeit ones will be detected and destroyed.
The RBI has no policy tools to attain this feat. Modi's decision in one stroke will achieve the rare feat.
BUSTING BLACK MONEY POOL
The second objective of unearthing black money will be attained to a great extent in an uncanny manner. By demonetising the old notes, all those hidden money will either have to be deposited in the bank or just destroyed.
The moment bundles of unaccounted money is deposited in banks, the Income Tax department will get a trail of it as current rules stipulates banks to send the information to I-T Department if someone deposits Rs 50,000 or more in one go. Even if the clever transaction are broken into tranches, the taxmen gets to know of the deposit once it crosses Rs 1 lakh in a single account. Taxmen will definitely follow up on these cases with scrutiny and penal action later on.
The fact that the Income Declaration Scheme (IDS), the Black Money (Undisclosed Foreign Income and Assets) and Imposition of Tax Act, amendments of tax treaties with Mauritius and Cyprus and other schemes have yielded Rs 1.25 lakh crore is proof enough of the gravity of the problem. Much of the black money is still stashed in the Indian household.
In 2007, the World Bank estimated the size of India’s shadow economy at 23.2 per cent of GDP. Assuming this ratio still holds, that’s about $479 billion unaccounted for. "Much of that money should get mainstreamed because of the demonetisation move," Crisil said in a note.
RATTLING REAL ESTATE
The steps to curb black money is a body blow to the real estate sector given that a significant proportion (about 60 per cent in Delhi) of the amount paid has to be in “black”.
Needless to say Modi’s initiative will not just deflate demand but actually lower real estate prices.
Much of the demand-supply gap will be determined by the extent of price fall. A back of the calculation shows property prices may come closer to the registry amount as the household as well as the builders will be wary to deal in black money.
TAMING INFLATION
When all the fake notes in circulation as well the black money comes under the banking system, the money available in the hands of the people will shrink. This will act as an effective deflationary tool without altering RBI's policy interest rates, Cash Reserve Ratio or the Statutory Liquidity Ratio.
Modi's hard step will be more effective than RBI's rate hikes as they are not fully transmitted by banks.
The fact that as unaccounted money keeps changing hands, it keeps fueling inflation in various forms especially property prices.
With September CPI inflation at 4.3 per cent, the move to curb black money and fake currency will have a direct impact in contracting demand and prices. This will help RBI lower rates further and arouse the animal spirits of private investors.
Over the long term, the government step could change the face of the Indian economy, improve the government’s fiscal position and tax compliance. "The size of the cash economy will shrink, as will black money generation avenues, because of better cash-flow trails. Inflation would tread down as demand slows in the short term, but the impact over the long-term would be neutral," opines Crisil.
MOVE TOWARDS E-CASH
The revolution has started but the government curb on illegal cash will only accelerate the move towards a cashless economy.
ItzCash, which has witnessed more than 30-40 per cent growth in the volumes traded since November 8, says it is only going to better the flow of physical cash within the economy while driving the digital mandate and thereby strengthening the "phygital" ecosystem of the country.
"However the bold alteration will mark a huge cultural, fundamental and behavioral shift in the Indian consumer’s mindset. Addressing it as a wake-up call, having witnessed an event of this nature and scale, people will now be more inclined to transformative changes. Adaption to digital cash will now find a sweet spot among public at large as a precursor to counter similar occasions while they leverage the immense convenience and seamless interoperability it offers," said Naveen Surya, chairman of Payment Council of India and managing director of ItzCash.
Fullerton India Credit Company's head of strategy and business execution, Anand Natarajan, says the demonetization Rs 500 and Rs 1000 notes has the additional long term structural impact of a more inclusive migration to a non-cash and potentially digital economy.
"Technology and digital commerce will now be all the more relevant, which in the long term improves vibrancy, access and reduces transaction costs."
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