Wednesday, November 09, 2016

Surgical strike on old Rs.500,1000 notes

by Ajay Shah.

What just happened? New Rs.500 or Rs.2000 notes will replace the role of the old Rs.500 or Rs.1000 notes. Large value notes will not go away. This is a surgical strike against the people who have inventories of the old notes that can't be shown to the authorities. Those people will find ways to fence those suitcases of cash, and suffer monetary loss in the process.

How do we interpret this move?

1. Unaccounted money is not synonymous with cash. Contrary to the depictions in movies, a lot of unaccounted money works through front companies which have bank accounts. It's not correct to equate corruption and tax evasion with physical cash. The impact of this move upon the black economy is smaller than we think.

2. Money is the lubrication that makes the market economy possible. In the short run, this will be a disruption for cash-intensive business models. As an example, the real estate business will suffer. Firms which have built a business model which does not involve cash will fare better.

3. The impact upon corruption will be small. Controlling corruption is not about blocking access to a non-traceable store of value. There will always be precious metals, US dollars, bitcoin, and jars of Tide. The facts on the ground could potentially evolve where women on the street ignore the government and continue to use 500 and 1000 rupee notes as a tool for achieving transactions. As long as people agree to use something as a currency, this suffices at a practical level, even without the State enforcing it as legal tender. Solving the problem of corruption requires deeper changes to institutions.

When the sources of corruption are unchanged, people will require some methods to achieve transactions. To the extent that people in India build business processes and business models that de-emphasise the use of Indian currency, that will increase the cost of doing business, and reduce the seigniorage income of the government..

4. This will not take us closer to the cashless world. This could be viewed as a way of pushing the post-cash electronic payments world forward. However, the institutional foundations of the new world have to be laid, and only at the tail end of that process, a certain use of coercion works okay.

As an example, NSDL was inaugurated in late 1996 and the entire machinery was working, all over India, well before the first mild SEBI coercion pushing people towards dematerialisation took place. The lockstep of those years -- of building good institutions and then gently using some coercion to favour the new world -- is the role model that we should apply on the migration to cashless. With the Indian payments industry, there are basic failures of the reforms, so the institutional infrastructure is not in place.  Today's coercion to push people away from cash will not lead them to electronic payments as the latter is not ready to receive them.

5. What do we know from past experience? India did this in 1978, and there was no disruption in the economy, but at the time, the rupee value of the currency notes which were denotified was small (Rs.160 crore). There are some international experiences where this worked badly. Burma did this in 1987, and got to riots and a coup in 1988.

I acknowledge useful discussions with Ashish Aggarwal, Suyash Rai and Josh Felman.


  1. Useful commentary, thanks. I have a few follow up questions, if you may answer:
    1) Do you have any kind of data which can tell us amount of hard cash circulating in black economy which might be affected via this move? It is a general saying that even in metropolitan cities we have 50/50 distribution between black and white distribution - so real estate dealers might be the one facing the most disruption, is it OK to assume that?
    2) Distribution of cash to buy votes is something that we hear a lot, will this have an impact on that, i.e. this move might lead to a fair(er) elections. What are your thoughts on this?
    3) How far are we from a cashless economy in terms of number of years (dematerialization was a great achievement in stock markets!), what timeline do you see for cash transactions.

    Net/net is it a positive step in your opinion or something leading to a coup(?) - that's way too extreme

  2. This measure while politically correct I am not sure has been thought through properly.Rich people have money in other colours and will manaage.The poor day labourer,vegetable vendor etc are today suffering.Sucking so much liquidity will hurt them deeply.All construction activity will come to a halt causing a deep recession and loss of work for the construction worker.Only time will tell how this plays out.

  3. This I believe is a masterstroke against fake currency. Also would create liquidity crisis for the cash economy. The direct impact could be there in the upcoming elections. The dealers of Hawala, whose liquidiuty is essential for the black economy and the back channels, would be the worst affected, unless they find means to launder their black money. As suggested, the invested black money may not get affected by this step

  4. can you deposit this currency multiple times in your current business account, I have a shop where the customer comes and offer me the currency of old notes, Do I accept them and deposit in my business account the next day

  5. 1. One aspect of this decision is how unpredictably it hit. So even though using cash to store unaccounted wealth/income will not stop completely after this, it can reduce the attractiveness of the same, if those doing so are going to fear similar unpredictable declarations in the future. Now, it is debatable how likely is such threat and how this incidence has been perceived by cash hoarders.
    2. It serves as a wealth tax since those who have way too large cash hoarding will have to lose some proportion of this cash among intermediaries and foot soldiers to retain partial value of those holdings.
    3. I think informal credit and daily wage laborers will face most heat. For other sectors, they can shift more or less swiftly to cashless or credit based exchanges. For large cash based transactions like housing, jewellery etc., I think post-Diwali lull in the market will minimize the impact.
    4. For real estate or Jewellery, I think some commentators have captured black-white transactions aspect between consumer and producer. But there might be much bigger role played by cash in the informal credit on which producers rely. Since such investors are set to lose part of their wealth, it will increase cost of capital and that might be the reason realty index experienced the correction. Buyer-seller cash transaction can be simply deferred by few days to avoid the current cash crunch.

  6. In case of the Govt's recent move, assuming some of the un-accounted Currency doesnt get back into the system, the Currency in circulation should reduce. Would this reduction in RBI's liability be transferred to the Govt as a windfall gain or remain in RBI's balance sheet as reserves. It would be great if you could share your perspective as to what would be done.

  7. [12/11 11:55 pm] Yogesh Joshi: I have few points to make

    1.Author says unaccounted cash is not synonymous to black money what is it denotes for ? Is it not tax evasion and if it is a white money then why those people's are not depositing money in Bank since there is no restriction on depositing money.

    2. If some industries are suffered for a short period then why should we worry if Long term impact is good.

    3. Magnitude if impact may be discussed but one thing is sure there will be a impact which we are witnessing.

    4.Since I am working in Banking industry for a quite long time I am witnessing a huge change in last ten years. Mechanism for cashless economy is already in place and increasing rapidly. There is a need change mindset of people's which is happening. In last few days there is a huge increase in electronics transactions.

    5.It is possible that earlier it might have failed I am not aware this time 86% of currency of total value is replaced which has not happened earlier ever.
    [13/11 12:01 am] Yogesh Joshi: Refer to the last remark on Barma where author says there were riots and eventually Government was changed by way of coup. I certainly think that if government has to go on this point then also it is worth doing this. Most of the people of India are happy with the decision and are ready to bear with the situation. I can tell you with first hand experience I am witnessing. People in long lines are also supporting the decision despite of problems they are facing.


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