The Unintended Consequences of Demonetization

By John Gallagher, International Business Editor

On November 8, India’s Prime Minister, Narenda Modi, went to extreme measures to flush out “black money” and force people with unreported wealth to pay taxes. The end goal of this policy is noble, but are the means are highly questionable.

The extreme measures included withdrawing India’s largest denominated bills, the 500 and 1,000-rupee notes (worth about $7.50 and $15) from circulation.  The two notes make up 86 percent of the cash in circulation. These measures would be comparable to President Obama declaring out of the blue, that $5 and $10 notes can no longer be exchanged for goods and services, and all outstanding notes must be deposited in the bank in exchange for $20 bills within the next two months.

However, in the United States, credit cards and plastic payments are a lot more commonplace. In India, most transactions for basic goods and food are paid for using 500 and 1,000-rupee notes. Indians have been flocking to ATMs and banks to exchange their cash for the newly minted 2,000 rupee notes. However, the government cannot print the bills fast enough to meet demand.

As a result, many small business owners are stuck with thousands of dollars’ worth of un-exchangeable notes. They cannot pay their workers or buy goods to keep their businesses running. In rural areas, this is leading to shortages. Indian supply chains are driven by cash rather than credit, as in the United States, so by rendering 86 percent of cash worthless, goods stopped being produced and moved to storefronts, leading to more shortages. As smaller bills are useless, prices naturally go up to compensate for the slowdown in volume, leading to inflation.

So Mr. Modi, why demonetization? The Financial Times cites rationale for this radical policy as “fighting rampant corruption, tax evasion and crime, as well as to deal with a surge in counterfeit notes being used to finance terrorist activities. The goal is to limit corruption amongst the rich, but it has wreaked havoc on the poor, while the rich have many of their assets locked up in foreign property and other noncash assets.

Ideally, what will happen is that black money will be flushed out of the system and the shadow economy, or the cash economy, will shrink. Currently, the size of India’s shadow economy is estimated at 20 percent of GDP. If successful, demonetization will lead to this large chunk of the economy being taxed, which will provide government revenues to improve infrastructure and to launch social programs.

In the long run, this policy may prove successful. It could lead to a more regulated economy that generates higher tax revenues, giving the government more flexibility to improve the country. However in the short run, GDP could contract as much as 2 percent, as commerce activity has declined substantially. This radical government policy, coupled with a shrinking economy could deter foreign investment in the short term. Another possible negative effect is that the Indian people could lose faith in the currency. After all, a dollar (or a rupee) is only what we believe it to be worth. If people lose faith and start to base prices off of gold, this could lead to hyperinflation and cause serious structural problems.

These would be big consequences for a poorly thought out plan to solve important problems in India. In the next month, the Indian government will need to print 2,000 rupee notes at a rapid clip, and allow people to exchange their useless notes. The sooner this happens, the sooner commercial activity will begin to pick up. It is important that this happens quickly to avoid layoffs and shortages.

A version of this article appeared in the Tuesday, December 10th print edition.

Contact John at

john.gallagher1@student.shu.edu

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