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The Cash Slash: A Silver Lining in India’s Demonetization

The Cash Slash: A Silver Lining in India’s Demonetization

As an Indian-born resident alien living in the United States, my newsfeed on November 8 was quite the spectacle. A quick glance at my Facebook homepage revealed an even split of despair and hope — and no I am not referring to the MAGA kind of hope. What I am saying is that the same day that drove most of my friends in the U.S. to despair, seemed to have given hope to my friends and family back in India.

On November 8, Indian Prime Minister Narendra Modi announced his plans on an unscheduled televised address to render two of the highest denomination notes of Indian currency worthless. His plan to demonetize the 1000 Rupee and 500 Rupee notes—to be replaced with newly printed 500 Rupee and 2000 Rupee notes—that accounted for 86% of all currency in circulation took a lot of people by surprise. A friend back home posted a status update praising Modi for this “surgical strike on black money.” Soon after, news media from all over the world began covering the event mainly through an optimistic lens. After all, India is known to have one of the most notorious underground economies; by some estimates only 1% of Indians actually pay taxes. Demonetization appeared to be nothing other than a targeted blow to tax evasion, terrorism, money laundering, and bribery, which all have cash at their core.

But as is with many sweeping policy changes, Modi’s move did not stand the test of time. Leading economists began criticizing Modi’s knee-jerk effort to curb corruption. The consequences of demonetization were largely borne by the economically underprivileged. Millions of people waited for hours in winding cues to get to banks to exchange their old notes for new ones; the rich usually had their workers stand in lines for them. Housewives who usually would save up money without the knowledge of their husbands or other family members were also exposed. As a cash-based economy, grassroots businesses were heavily affected by the shortage of cash. While it has been argued that this shortage was exaggerated and largely cushioned by the formal and informal credit industry in India, I find it difficult to ignore the countless anecdotes of suffering.

To make matters worse, the underground economy in India had devised ingenious ways to convert their black money into legal tender. Some of these methods are truly jaw-dropping. Take for instance, the priest  in Mathura—-a sacred city in northern India— who was willing to accept 50 Lakh Rupees ($73,600) of black money as a ‘donation’ to convert to white for a commission of 20%; a scheme that was possible because temple donations were shielded from government scrutiny. If that does not meet your bar for creative, then there were people booking and canceling train tickets to replace old bills with new ones for a mere cancellation fee. Another strategy used by the rich was to use underprivileged people to deposit their money only to return it at a later date.

As Bloomberg also reports, “…the government has been working to close loopholes -- which Prime Minister Narendra Modi decried as people’s "illegal means to save their ill-gotten wealth" in a radio address last week -- new ones are opening even faster. So far, the policy aimed at reducing the scale of the black economy and bringing more people into the tax net is, in the short term, leading to just the reverse: money-laundering, tax-avoidance, and new opportunities for existing organized crime, the evolution of the long-standing hawala money-transfer system, and the start of new illicit networks.” In summary, as opposed to paying taxes and stiff penalties on their black money, people concocted various means to exploit systemic loopholes.

The more I read up on the effects of demonetization, the harder it became to see much value in my country’s move, at least in the short-run. From where I was sitting I could see two reasons why this failed in the short-run: A large portion of black money was converted to white, as the economically underprivileged were reduced to collateral damage.

With that said, I couldn’t shake the thought of its potential impact in the long-run. Could this policy have any benefit if we were to contextually zoom out?  

The answer is: possibly.

Demonetization may not have ‘seized’ much black money—since a large portion of it was converted to legal tender—but it certainly put chains on the wheels of this underground economy. By ridding them of their most crucial ingredient—cash—the move likely reduced their confidence in paper currency. The underground economy can and probably will begin accumulating black money in newly issued notes, but doing so would take a lot of time.

What’s more is that this overall lowered confidence in paper currency may have nudged the country towards a less-cash society. People would naturally be less likely to hoard cash due to the fear that the government could simply demonetize again. As a result, people would also be more inclined to get bank accounts—a prerequisite for a less-cash society. This idea of a less-cash society is very contentious, but this might still be the silver lining I was so desperately seeking.

As you can probably guess, economists have researched the perils of cash extensively. A group of Economists, and most notably Kenneth S. Rogoff of Harvard, have been promoting the idea of societies with less cash. In his recent book, The Curse of Cash, he lays out a plan to phase out large denomination bills in the U.S. such as the US $100 bill. According to his plan, people would have the opportunity to exchange or deposit these bills over a period of seven years, and the convenience of doing so would progressively decline with time.

The purpose of this policy proposal brings into question the benefits of a less-cash society. Expectedly, the first reason is because cash facilitates the underground economy. On the other hand, the second reason is less obvious and relates to the functioning of central banks.

In the U.S. itself, there are about 1.3 trillion dollars of currency in circulation, of which over 78% is denominated in $100 bills. That is to say that there are around $4000 dollars in $100 bills for every person in the U.S., and yet most people rarely transact in hundred dollar bills. Rogoff also points out that the domestic demand for these bills is dwindling with the surge in cashless payment systems (read: credit/debit cards, Paypal, Venmo, Square, etc.). Furthermore, most of these bills held domestically are presumably used in the underground economy. By some measures the underground economy has been estimated to be between 7% and 12% of GDP. This underground economy consists of all forms of corruption including but not limited to drug trade, terrorism, money laundering, tax evasion, and bribery. Although all denominations of paper currency fuel this underground economy, large bills certainly steal the cake. It is dramatically easier to transport and store $1 million in $100 bills as compared to utilizing $10 bills. While the former configuration would require the ability to carry about 22 pounds in a backpack, the latter measures up to several suitcases weighing approximately 220 pounds.

In addition to facilitating this shadow economy, cash also reduces the effectiveness of central banks. Central banks are tasked with targeting interest rates based on the health of the economy. Typically, this interest rate is the amount commercial banks receive for parking their funds at the central bank. During times of recession, the central bank would target a lower interest rate so that the banks are incentivized to lend out the funds rather than leaving them at the central bank.

This poses a big problem in today’s low interest rate environments, especially in the U.S. Low interest rate environment implies that the next recession would warrant a negative interest rate policy on the Federal Reserve’s behalf. Although negative interest rates are a highly debated and combative issue, they may be required to kickstart an economy operating at a close-to-zero interest rate environment during a recession. However, the existence of paper currency—mainly high denomination bills—would cause bank-runs as people would resolve to hoard their cash; the idea being that individuals would prefer receiving no interest as opposed to negative interest, essentially being charged a fee to leave their money at a bank. As a result, this much-needed negative interest rate policy would be ineffective and mainly result in chaos.

With that said, it is important to note that countries such as Denmark, Sweden, Switzerland, and Japan, have already used negative interest rates to fuel their economies. And that there was not much evidence of cash hoarding as a result. But that is mainly because the rates were not that negative (minus 0.75 at the extreme end in Switzerland), and because bank’s retail customers were less affected than the banks themselves. In the case of Sweden, the surge in electronic payment systems and the decrease in the higher denomination 1000-Krona notes made it less convenient to hoard cash. As a whole, economists agree that a longer period with more negative rates could result in people resolving to hoard cash. Rogoff’s point still stands that we could see bank-runs for cash in periods of significant and sustained negative interest rates.

Cash clearly has its shortcomings—firstly, it facilitates a shadow underground economy, and secondly, it renders the central bank less effective in dealing with economic downturns in a low-interest rate environment.

Whether it was intended or not, this slight push towards a less-cash society might just be good for India. This is obviously contingent on you believing that the benefits of less-cash society outweigh its costs. There are a lot of people that voice their concerns that less cash and more electronic payment systems would be an attack on privacy, and the anonymity that is implicit in cash-based transactions. I tend to believe that the benefits of less cash outweigh the cost of maybe living in an Orwellian dream.

If we assume for a minute that the benefits do in fact overshadow the costs, it might be interesting to look at ways in which countries could demonetize in the future. In other words, how could have India demonetized without throwing the poor under the bus?

The solution is quite simple and lies in Rogoff’s proposal. As mentioned earlier, Rogoff argues for a gradual phase-out of large denomination bills in the U.S. over a period of seven years where it would become progressively difficult to deposit these notes. Rogoff argues that these large denomination notes be entirely phased out and replaced with lower denomination notes. India could have similarly taken the path of gradual replacement of old bills with newer ones. Primarily because demonetizing abruptly did little to nothing in penalizing the black market, and because its alternative of demonetizing gradually would have had a similar effect while also safeguarding the well-being of the underprivileged.

As a whole, there might be a silver lining in demonetization, but we have to ask, at what cost. This is not just a demonetization problem, or an India problem, but rather is an issue that is pervasive across policy choices and national boundaries. And the onus rests on all decision-makers to do everything in their power to limit this collateral damage. Currently, it just does not feel like they are trying hard enough. For instance, take the civilian casualties in Obama’s ubiquitous drone strikes, to the people that might die because of a Trump-led repeal of Obamacare, and the one commonality you will find is a disregard for collateral damage. The end result: Women and men in India sign up for a government program that offers cash as an incentive to get sterilized.

For what? To put food on the table.


The views presented in this piece do not reflect the views of other Arbitror contributors or of Arbitror as a whole.

 Photo: "Long queues before bank in Darjeeling, India" Originally taken by Monito with a CC license. Use of this photo does not indicate an endorsement from its creator.

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