Demonetization is a net positive move

Scaling back large bills will not end crime, but it will force the underground economy to employ riskier methods

In a special broadcast on 8 November, Prime Minister Narendra Modi announced a positive exogenous shock to the country. He declared that in less than four hours, Rs500 and Rs1,000 bills would be demonetized, thereby withdrawing their status as legal tender. India has one of the highest levels of currencies in circulation at over 12% of gross domestic product and of this cash, 87% is in the form of Rs500 and Rs1,000 notes. Globally, this is not unusual. Central banks of several countries pump massive amounts of cash into the economy, mostly in very large denominations. In the US, $100 bills account for 80% of the cash supply. In Japan, ¥10,000 note (about $100) accounts for 90% of total cash holdings. Across countries, most of this cash has been supporting underground black economies. For decades, economists such as Ken Rogoff and Richard Thaler have been arguing for a less-cash economy because it is safer and fairer.

The timing of this announcement seems obvious, in hindsight. With the massive rollout of the Pradhan Mantri Jan-Dhan Yojana (PMJDY) in India, citizens’ access to bank accounts is nearly complete. A demonetization move would have been impossible if low-income households were unbanked. PMJDY has provided them with free bank accounts, which will also be used to transfer government payments. The need for honest people to stash cash in mattresses, therefore, has diminished. This move by the PM has also followed the income disclosure scheme where people were given a window of opportunity to declare their wealth amassed through various means. It was an appropriate time, therefore, to make credible the threat of a crackdown on black money and corruption within India.

The next few months will be painful, and should be seen as teething troubles for an economy trying hard to reform its corrupt self. There will be an urgent need for debit cards, electronic transfers and mobile payment platforms to be widely adopted. Behaviours change slowly, especially for those set in their ways. Institutional support from financial institutions, telecom platforms and payment interfaces will have to rise to the occasion and fill the supply gap. They will have to adapt to the ways of all, particularly those that are new to formal financial transactions. But there is more hope than ever before. My driver in Delhi gets his daily supply of Mother Dairy milk pouches using a Paytm card! If my friends at the Delhi Race Course used the same technology, they would be a happier lot today.

As an economy we should aim to go less-cash, and not cash-less. Cash greatly facilitates transactions and that is why the government will introduce new Rs2,000 bills because there are legitimate high value transactions in every economy. The fundamental idea behind this exogenous shock is to raise the cost of illegal transactions. Cash facilitates crime because it is anonymous and big bills are easy to carry. So going less-cash is a fine balance between maintaining ease of financial transactions and curbing malpractices. Besides, the new Rs2,000 bills have been designed with enhanced security features, so this is not just new money replacing old money in the system.

Will this eradicate black money and corruption in India? Some “experts” have warned that Indians are creative and will find ways to circumvent this demonetization. That’s true there are ways to bribe officials, make criminal transactions and evade taxes without Rs500 and Rs1,000 bills. But removal of large bills will make several criminal and illegal activities more costly such as tax evasion, human trafficking, drugs, extortion and terrorism. Scaling back large bills will not end crime, but it will force the underground economy to employ riskier and less liquid payment methods. There is reason, therefore, to believe that this move will reduce corruption and several forms of criminal transactions in the economy.

The effect of this policy is not going to be uniform across the economy. Sectors that have a larger cash component in their transactions will be hit harder, such as real estate, movie production, campaign finance, etc. This will then be followed by a correction in these markets. Whether these corrections are deflationary (reducing prices) or contractionary (reduce business) is something to watch closely. However, these are corrections which will move the market equilibria to outcomes which reflect genuine demand and supply in the real economy.

In the long run, this is a significant positive shock to the Indian economy and society. If substantially implemented, this will send a strong signal about India’s anti-corruption drive and is very likely to improve the country’s reformist stance. It also provides a boost to the government’s financial inclusion drive, pushing more households towards efficient banking and payment infrastructure. In the immediate run, we are likely to witness larger bank deposits, price corrections and better tax collection possibilities in the economy all great for Indian bonds.

This is not the first government to demonetize large currency bills. The European Central Bank has announced that it will phase out the €500 mega-note, much against the preferences of cash-loving Germans. The benefits of phasing out large paper currency are significant to an economy and even more to a society such as India where corruption has become an acceptable way of life. Modi has tightened the seatbelts and honest Indians are optimistic about the joyride ahead.

This article first appeared in the Mint on November 10, 2016. Like other products of the Brookings Institution India Center, this article is intended to contribute to discussion and stimulate debate on important issues. The views are of the author(s). Brookings India does not have any institutional views.