86% Of Indian Currency Now Illegal: Masterstroke Or Big Blunder?

What does the scrapping of Rs 500 and Rs 1,000 notes mean for the economy?

(Photo: Reuters)

By the time you click on this piece, any Rs 500 or Rs 1,000 currency notes you may have in your wallet will be essentially worthless. You have 50 days to exchange the notes at banks and post offices but you can’t use them to pay for your pizza.

If you think you are going to be inconvenienced by the government’s sudden move, think about what it means for the broader economy.

First a quick recap. On Tuesday night, Prime Minister Narendra Modi announced that notes of Rs 500 and Rs 1,000 denominations would no longer be “legal tender”. The move is intended to fight corruption, black money and money laundering. In short, the idea is to bring the parallel economy to a halt.

While there are no clear estimates about the size of the informal economy and hence the impact on it, there are a few ways to understand the impact on the formal economy, at least in the near term.

Prepare For A Cash Crunch

Rs 500 and Rs 1,000 notes were discontinued from Tuesday midnight as a step to curb black money. (Photo: PTI)

According to the Reserve Bank of India’s (RBI) annual report, the total value of currency in circulation is Rs 16.4 lakh crore. Of this, 38.6 percent or Rs 6.3 lakh crore is in the form of Rs 1,000 notes. Another 47.8 percent or Rs 7.8 lakh crore is in the form of Rs 500 notes.

This means that over 86 percent of Indian currency will be withdrawn and needs to be exchanged before it can be used.

Some part of this currency will be black money and may not come into the formal economy, although since the window to use this money has been abruptly closed, people may have little choice.

In the very short term, as the switchover takes place, there will be a shortage of currency which will impact economic activity.

According to FAQs published by the RBI, you can get up to Rs 4,000 in cash when you give in your Rs 500 and Rs 1,000 notes. The rest will be credited to your account. Cash withdrawals, over the bank counter, will be restricted to Rs 10,000 per day subject to an overall limit of Rs 20,000 a week from 9 November till the end of business on 24 November. Withdrawals from ATMs will be restricted to Rs 2,000 per day per card up to 18 November and the limits shall be raised to Rs 4,000 per day per card from 19 November.

What this means is that there will be a shortage of cash in the system at least for the next two-three months, which could impact low-value transactions across consumption-driven sectors. This will subdue economic activity and growth in the near term. Economists will undoubtedly work their models and give us some estimates of how bad the hit will be in the coming days.

The Ripple Effect

What is much tougher to gauge is the second-round impact of a move like this. If the worst fears about India’s large parallel economy are true, then the ripple effect of this move could be felt for some time to come.

An obvious place to start as we try to understand the impact of this move is the real estate sector. While the cash component in real estate transactions has gone down over the years, it still remains considerable by all accounts. This is particularly true in the secondary real estate market and in the case of high-value properties.

Real estate developers may now have no option but to drop prices. (Photo: iStock)

Real estate developers, who were holding on to prices by their teeth, may now have no option but to drop prices faced with a sudden drop in potential buyers. Given the multiplier effect that a sector like real estate has on the economy, a steep slowdown in that sector will hurt many others. From banks, who lend against real estate and take real estate as security, to daily wage construction workers, who depend on the sector for income, there will be collateral damage from any steep slowdown in the real estate sector.

(Photo: Reuters)

There are a host of other sectors, from unorganised trade to the medical profession, that are skewed towards cash payments. While no one is arguing that activity in these sectors will come to a standstill, it is tough to see how the level of activity will not be impacted.

Pay some attention, also, to the famed wealth effect. If the stock market reacts negatively to this, and real estate prices correct further, consumers may feel less upbeat about their financial position and hold back on spending.

The Indian real estate market is expected to touch $180 billion by 2020, according to estimates by the Ministry of Finance and CREDAI (Confederation of Real Estate Developers Association of India). The housing sector alone contributes 5-6 percent to the GDP.

Moving Towards Long-Term Goal Of A Formal Less-Cash Economy

While we prepare for some short-term pain, it may help to dull the hurt by thinking about the long-term goals that a move like this could help achieve.

The first, as the government said, is to bring the parallel economy to a standstill. By withdrawing high-value currency notes, you curtail the menace of black money. What is puzzling here (and may allow the problem to come back) is the government’s decision to introduce Rs 2,000 currency notes. If the idea was to take higher denominations of currency notes out of circulation, the government should perhaps have stayed away from introducing an even higher denomination note.

New Rs 2,000 note. (Photo credit: ANI)

The second implication of this decision could be to hasten a move towards a less-cash society which many argue will only benefit the economy. This is true not just for India but across the globe.

In a September article written for the website Project Syndicate, economist Kenneth Rogoff had argued in favour of taking higher denomination notes out of circulation across all economies saying that the use of cash in the legal economy is reducing.

With the growth of debit cards, electronic transfers, and mobile payments, the use of cash has long been declining in the legal economy, especially for medium and large-size transactions. Central bank surveys show that only a small percentage of large-denomination notes are being held and used by ordinary people or businesses. Cash facilitates crime because it is anonymous, and big bills are especially problematic because they are so easy to carry and conceal. A million dollars in $100 notes fits into a briefcase, a million dollars in €500 notes (each worth about $565) fits into a purse.

Kenneth Rogoff, Professor of Economics, Harvard University (on Project Syndicate)