Demonetization of Rs.500 and Rs.1000 Currencies : The Cause and Effect Analysis

Demonetization of Rs.500 and Rs.1000 Currencies : The Cause and Effect Analysis

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The decision to scrap Rs500 and Rs1,000 currency notes was taken to create a “corruption-free” India, Prime Minister Narendra Modi said on Wednesday as a number of people welcomed the step. It is being called a master stroke by PM Narendra Modi, the Rs. 500 and Rs.1000 denominations will now be out of circulation from the Indian economy.
Some economists say demonetization will adversely impact India’s economic growth even as others believe the disruption is unlikely to be significant
Lets have a look at the cause and effects of the decision to demonetize Rs.500 and Rs.1000 currencies.

Why Government decided to demonetize Rs.500 and Rs.1000 currencies :
To tackle black money in the economy as India, 3rd Largest Conuntry in Supply of Dirty Money ( Black Money).
To lower the cash circulation in the country which “is directly related to corruption in our country, ” according to PM Modi.
To eliminate fake currency and dodgy funds which have been used by terror groups to fund terrorism in India.
The move is estimated to scoop out more than Rs 5 lakh crore black money from the economy.

black-money

Other Reasons, Excrept from Speech of PM Modi :

  • The honest citizens want that government fights against corruption, black money, benami property, terrorism and counterfeiting.
  • The magnitude of cash in circulation is directly linked to the level of corruption.
  • Between 2011 and 2016, the circulation of all currency notes, from the lowest to the highest denomination, grew about 40%.
  • In the same period, the circulation of Rs 500 denomination and Rs 1000 denomination currency notes increased by 76% and 109% respectively.
  • But, the size of Indian economy during this period expanded by only 30%.
  • So obviously there has been a disproportionately high usage of high denomination currency notes.
  • Inflation becomes worse through the deployment of cash earned in corrupt ways. It has a direct effect on the purchasing power of the poor and the middle class.
  • In purchase of land or a house, apart from cheque, a large amount of cash is demanded.
  • Thus, misuse of cash has led to artificial increase in the cost of goods and services like houses, land, higher education, health care and so on.
steps-to-control-blackmoney
Source : http://www.livemint.com/r/LiveMint/Period2/2016/11/09/Photos/Processed/w_black_money.jpg

Related things you must know

  • A legal tender is any acceptable currency in a country. The denominations are declared by the government.
  • In India, different values of the Indian rupees are legal tender. The Reserve Bank of India (RBI) Act and the Indian Coinage Act specify which bank notes and coins will be legal tenders.
  • The Central government under Section 26(2) of the RBI Act has the authority to declare currency as not valid legal tender. This is generally done on the advice of the central board of directors of the RBI.
  • Section 24 of the RBI Act empowers the Central government to issue bank notes of any value, as long as it is Rs.10,000 or below. Hence, there is no amendment in law required for any changes in legal tender.
  • Recently, the Central government has declared that Rs.500 and Rs.1,000 will not be accepted as currency notes, thus these two denominations are no longer legal tender. Hence, these notes have no value.
  • It means that people cannot use existing Rs. 500 and Rs. 1,000 currency notes for monetary exchanges.
  • Also, the central government is set to introduce two new currency notes of value Rs.500 and Rs. 2,000.

Numbers you must know, related to this decision : 

  • According RBI’s database on Indian Economy, currncey notes worth Rs 17,54,000 crore are in circulation.
  • Aprox 86% of currency by value in India are of Rs 500 & Rs 1,000 denominations
  • In terms of value, Rs 500 notes constituted almost 45% and Rs.1000 notes constituted alomost 39% of the currency in circulation.
  • In terms of volume, Rs 10 and Rs 100 notes constituted 53% of the notes in circulation.
  • After the decision of Rs.500 and Rs.1000 currency ban, almost Rs 6,32,600 crore in circulation in the form of Rs 1,000 notes would be illegal tender.
  • To replace Rs.1000 currency in circulation, Rs 2,000 notes have been introduced, limited in circulation according to the government.
  • Only Banks and Postoffices are the only place where old Rs.500 and Rs1000 currencies can be exchanged with new ones ( after showing some valid ID).
  • RBI data shows that in 2015-16, almost 6.5 lakh counterfeit notes were detected in commercial banks of which almost 4 lakh were in the Rs 500 and Rs 1,000 category.
  • It is in this context that the government wants to re-monetise the Rs 500 note while de-monetizing the Rs 1,000 note.
  • But the number of Rs 100 counterfeit currency were also close to 2 lakh this year.
  • Considering Banks and Post Offices only places to exchange and deposit moneny, the fake currencies will be of no value.
  • In addition, the new currencies are of new designes, that eliminates the risk of mixing old currency with new.
  • Figures show that the strongest currency chest in India is with the State Bank of India (SBI), which has 1965 of them.
  • Currency chests determine the amount of bank notes supplied by the RBI to various banks.
  • Nationalised banks meanwhile have 1,173 chests while SBI’s affiliates have 757 chests and Private banks have 160 chests.
  • Considering the greater number of currency chests in state owned banks, the number of people heading to these banks would be far greater.

Effects of this decision : 

Incidentally, the decision comes close on the heels of the expiry of the September 30 deadline of the black money disclosure scheme under which income and assets worth Rs 65,250 crore were declared.
With almost 60% of the economy estimated to be a cash economy, the decision is likely to be quite disruptive in the short-term.
India is a cash-based economy, hence the circulation of fake rupees continues to be a menace. The fake notes are used for anti-national and illegal activities. Thus, it is now expected to contain the rising incidence of fake notes and black money.
The decision is also expected to severely impact sectors that deal with unaccounted money such as real estate, stock market and gems and jewellery.
However, it will also hit the livelihood and savings of neighbourhood vegetable vendors who borrow overnight funds from moneylenders, kirana stores, small traders and even the labour class.
There will be temporary glitches occurring due to the transient nature of replacing the currency but the RBI is already ready with new currency notes of Rs. 500 and Rs. 2000 to meet the requirements in upcoming weeks and days.
In addition, the government has made clear that the now defunct two denominations in bank accounts will not enjoy immunity from tax and the law of the land will apply on source of such money.

Lets see it categorically : 

Cabs Services: People using cabs like Ola or Uber will prefer to load money into their wallets rather than pay by cash from now on. The probability of having cash to pay the exact amount will be difficult . This is also an indicator to auto-rickshaws that they need to move to a non-cash-based format in order to survive.

Local kirana stores: While grocery stores and supermarkets do accept cards, very few kirana shops have the card facility. Even if it is there, people have a tendency to pay in cash in these places. With many supermarkets tying up with wallets and they being the’ target segment for the recently-launched Unified Payment Interface (UPI), the unbanked population might also be driven on this road. Therefore, the ration shops will need to transition to the digital platform.

Shopping from e-commerce websites: A lot of people hesitate in buying high-value goods lie electronic equipment online. People still consider buying a power bank or a mobile phone risky , so such people are likely to be affected.

Unorganised labour: Construction workers, household helps and the local sabziwallahs, among others, may find it difficult initially to understand the system of using digital payments but slowly need to adapt themselves. Payments to them by individuals are generally made in cash.

Doctor/tuition fees: Fees of nominal value will be a challenge for people, for sometime now. Cheques/cards and wallets can now be used to make payments.

Restaurants: Roadside dhabas and small eating places generally only have cash-payment facilities. Even when placing online orders, the use of card/wallet payments should become more effective now.

Railway bookings: Those who buy tickets, while standing in a line in the railway stations generally pay cash. This ban on illegal notes should push for more online bookings.

House renovations: Petty tasks such as plumbing, house painting or even electrical repairs are mostly cash-based. These people will also find it difficult in the initial days to adjust to these changes.

Automobile Industry : There may be a near-term drop in sales volumes because of the disruption caused by the withdrawal of existing Rs500 and Rs1,000 notes. But this comes in the backdrop of reviving consumer demand that has seen sales growth improve for cars and two-wheelers. Thus, this can only be small and temperory disruption. Though Luxury car segment can face a hit as unaccounted money has reportedly been in circulation in the luxury car segment.

Gold and Silver : Gold has been a popular mode to hoard black money apart from real estate and is a popular mode of savings, even among the poor. The government’s move to take out high value currency notes is expected to adversely affect the business of jewellery companies. CLICK HERE TO READ IN DETAIL

Real Estate : The move to take existing high-value currency notes out of circulation is likely to hit real estate companies the worst. The sector is known to be a safe haven for converting stock of black money into white, especially in high-value transactions. CLICK HERE TO READ IN DETAIL

FMCG Industry : Consumer staples may not see a sizeable impact, though some down-trading to lower value packs may be seen. Discretionary consumption may see some impact as consumers with a liquidity crunch may become choosy on where they spend.

Effect on markets
The Sensex is made up of very large companies which may not be impacted as much by the demonetization process.
The largest impact of the government’s move will be in the unorganised sector, which isn’t represented in the markets.

Effect on voter base
The decision may affect the current ruling majority party’s key support base—traders, small and middle-level businessmen. However, many feel that traditional party supporters like lower/middle class will not find it tough to account for or exchange the currency. The real fear will be for those who have unaccounted money.
As per analysts, with assembly elections due in five states over the next six months (Uttar Pradesh, Punjab, Uttarakhand, Goa and Manipur all go to polls), the move is risky and brave.
Elections attract cash, and the move means “campaigning is going to be a big headache for political parties”
Thus, this move is expected to bring more transactions under tax net, both direct and indirect taxes would move up, more digital transactions will take place and reduction in parallel economy will increase the size of formal economy as more people will disclose income and pay taxes. This will make India a more tax-complaint society.

Immediate Impact: Heavy Deflation :
Initially there will be heavy deflation as people who have earned money through illegal means such as smuggling, corruption would be afraid to declare the money as they might be prosecuted by Govt/Income Tax Dept on the legitimacy of their income.
This will reduce the total currency circulation in the economy – leading to deflation. Deflation increases the value of money that we have because the total money supply goes down but the commodities and things available in the market have not gone down. Gold prices, stocks & commodities will drop.

Lead to Inflation (not overnight) :
There will be a lot of people who have a lot of cash, legally earned, which they will deposit it in the bank.
Now the bank with more deposits can do more lending.
Credit (loans) will become easier and interest rates may come down. More loans given out increases broad money supply and creates inflation. But this will happen slowly, not over-night.
Deflation and Inflation will balance out each other in the future.

Who needs to worry?
Not the honest taxpayers. Even if you have Rs 10 lakhs as cash with you and you can prove its legitimacy, you don’t need to worry.
The surprise move by government is a disaster for people who have accumulated lakhs and crores of unaccounted cash under their pillows and mattresses. The winter is coming and these worthless pieces of paper can provide the corrupt some ephemeral warmth.

What experts think?
Almost all the stalwarts of the banking sector including Deepak Parekh, Chanda Kocchar think that the move will help curb black money in the economy.
According to MD & CEO, ICICI Bank Chanda Kochhar who told ET Now, “this move will definitely bring about a whole amount of transition to no cash or low cash kind of transactions,”.
“A parallel black economy will collpase,” one of the leading lawyers in taxation laws, Harish Salve told ET Now.
Narayana Murthy, founder of the Infosys, welcomed the government’s move in its fight against corruption. Murthy also added that “the dishonest will have to suffer, absolutely that is the right thing.”
HDFC Chairman Deepak Parekh anticipated that the Land will become cheaper and “one expects that real estate price will come down in medium term.”
But with all the positives, government has not been able to explain anything for the people who don’t have a bank account.

By-
Alok Upadhayay
Source : Various Print and Electronic Media

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