Demonetisation update 1: quick thoughts

Bells and whistles and links will be added later. These are quick thoughts. Happy and grateful to be corrected on conceptual and factual error. Other disagreements will be mere arguments and they are not usually productive).

(1) Well timed and well executed. Political credibility enhanced. Politically astute too. Many have said that already.

(2) Timing this after the end of the tax amnesty scheme was logical.

(3) No capital flight and no ‘rupee is toast’. Overstated. Everything else being equal, withdrawal of currency in circulation, in the short-run, will actually drive up interest rates and positive for the currency. May not happen as not all things are equal. Capital flight is not that easy anymore. Tax authorities around the world co-ordinate and there is uncertainty in every currency and perhaps more so. Therefore, ‘rupee is toast’ is far from a likely scenario.

(4) What Professor Kenneth Rogoff (Harvard) suggested for the USA was extreme financial repression in the context of zero and negative rates. That was a very bad and toxic suggestion. Here, it is not the case. Nor is this an act of ‘financial fascism’ or that of a totalitarian state. Those are wrong characterisations. No. Citizens are entitled to redemption of old currency notes and they can do so. If ill-gotten and concealed, then where is the right that is being deprived?

(5) Short-term liquidity squeeze could be severe and hence economic activity could suffer. Can last up to two or three quarters. If less, well and good. CLSA and Credit Suisse seem to think that (adverse) economic impact could be significant.

(6) Further, with the eventual design of the GST looking more complicated than originally envisaged and with the timelines getting shorter, uncertainty could be compounded. That risk is non-trivial.  That is why GST should have been more concerned with simplicity, ease of use and implementation rather than revenue considerations. Bold thinking was always needed and more so, in the light of this announcement.

(7) In other words, a lot of learning is required of private sector participants to adapt to the new regimes – GST and de-monetisation. It will cause dislocation and uncertainty while learning happens and, two, it takes time.

(8) The government could have and should have (it still might) come up with additional economic stimulus too, to offset the dampening effect. Just thinking aloud here: (a) accelerated reduction in corporate income tax along with withdrawal of exemptions; (b) ending uncertainty on GAAR and retrospective taxation or any other blockbuster measure that they might be working on, that would offset the initial adverse economic impact.

(9) Whether this would boost eventually economic activity that is formal remains to be seen. But, orders of magnitude are very difficult to establish and hence, any claim of such improvement in formal economic activity with consequent beneficial tax impacts and other social economic multipliers must be deemed wholly speculative at this stage.

(10) This will not release money for RBI to recapitalise banks. A flow diagram of how it would happen – with money going from RBI to GoI and from there to banks, as a result of this de-monetisation and consequent reduction of currency in circulation – would be helpful. Otherwise, it is fanciful. I have not seen one.

(11) Sovereign credit rating – no impact. Indeed, the risk of a downgrade is as real (or more real?) as that of an upgrade, if short-term impact on economic activity dampens government revenues and widens deficit. No government debt is being cancelled.

(12) Tempting to imagine economic benefits immediately from a structural reform. But, these things usually come with a long lag, if they do and, in the short-term reform or deviation from ‘business as usual’ usually results in pain and uncertainty. That is the reality.

This one page flyer is a good one. RBI’s FAQ begins with a reference to curbing the menace of fake notes, terrorists, etc.:

1. Why is this scheme introduced?

The incidence of fake Indian currency notes in higher denomination has increased. For ordinary persons, the fake notes look similar to genuine notes, even though no security feature has been copied. The fake notes are used for antinational and illegal activities. High denomination notes have been misused by terrorists and for hoarding black money. India remains a cash based economy hence the circulation of Fake Indian Currency Notes continues to be a menace. In order to contain the rising incidence of fake notes and black money, the scheme to withdraw has been introduced. [Link]

My good friend Praveen Chakravarty raised the question of why the government was printing the new Rupees 2000 note when it was eliminating the old 500, 1000 rupee notes? – high denomination notes? It is a good question for which I do not have the answer. But, I can infer one thing. It might be a solution to address the practical dimensions of keeping the scheme open for exchange only for about two months. If the 500 and 1000 rupee notes had to be replaced, a 2000 rupee note would suffice for 4 notes of Rupees 500 and 2 notes of Rupees 1000 each.

The government was keener to address the stock of existing high denomination notes than to arrest the flow of them drastically for the future. In any case, in the Prime Minister’s prepared speech to the nation, he made an important point:

Based on past experience, the Reserve Bank will hereafter make arrangements to limit the share of high denomination notes in the total currency in circulation.

You can find the speech in by choosing the date ‘8th November’ in the drop-down menu on the left side.

So, high denomination notes will not be so easily available going forward. So, having struck a dagger through the pile of the current stock of high denomination notes, the government has accepted a new 2000-Rupee note to handle the transition and then, in future, it aims to limit the stock of these notes. Sounds logical to me.


6 thoughts on “Demonetisation update 1: quick thoughts

  1. Dear Sir,
    Thank you for your perspective about India’s de-monetisation scheme. Your views as usual are unbiased & stimulating. I had couple of questions:

    1. Total cash which has been taken out of circulation is Rs. 14.2 lac crores. Out of this roughly 5 lac crores should come back to the system & out this 5 lacs crores roughly 40% will move out again (as households had legitimate cash in hand which comes in for exchange & some 40% moves out for expenses as we are a cash based economy for daily needs etc) so the balance 2 lac crores remains with banks as low cost deposits. As the corporate credit growth is tepid mainly due to low capacity utilization so does this 3 lac crore acts as recapitalization for these banks.

    2. Do you think there’s a good chance of Govt/RBI going in for Rupee Devaluation? Why I ask this is because I didn’t get the logic of issuing 2000 rupee note & its more puzzling today when the new 1000 rupee will also be issued.




    1. 1000 Rupee notes will be issued in due course. not now. Issuing 2000 rupees is to make it easy for the exchange to happen. It is a practical convenience decision. Of course, the optics looks confusing.

      The decision by the Government was to liquidate the existing stock of 500, 1000 rupee notes rather than to end high-denomination notes for ever. That would come much later when the Indian economy would be less cash-intensive.

      Devaluation? Why? I do not get it.

      On the issue of this money being used for bank recapitalisation, even the experts are not clear as to how it is feasible. It may not be advisable to do it this way. It might set an unhealthy precedent.


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