Founded in 2016, Ceteris Paribus is A student-led economics and finance publication at Davidson College.

India's Demonetization Problem

by Shiv Palit

 

Indian citizens wait in line to use an ATM. (Photo via Reuters)

Indian citizens wait in line to use an ATM. (Photo via Reuters)

Standing seventh in nominal GDP and third in purchasing power parity, India has now become one of the most important economies in the world. Its economy is heavily reliant on the service and manufacturing sector, which contributed to 57% of their GDP in 2012-2013. Although it has sustained a strong growth rate of over 7% for the past five years, the Indian economy’s potential far exceeds its reality due to the overwhelming presence of corruption in government.

In November 2016, Indian Prime Minister Narendra Modi announced India’s demonetization plan that aimed to remove illegitimate or “black” money, obtained through illegal bribes or corruption, from circulation in the Indian economy. The plan banned 500 and 1,000 rupee notes from being used for transactions, which accounted for 86% of the cash in circulation, with the belief that most “black” money in India exists in these forms. Citizens are able to exchange up to 4,000 rupees in banned notes to legitimate cash, and any amount into bank accounts with proof of its origin. However, large deposits will be subject to taxation, which would help in reducing India’s budget deficit, as well as auditing. It is estimated that approximately 3 lack crore (trillion) rupees in black money will be extinguished from the economy as a result of the ban. Along with the demonetization policy, the State Bank of India (SBI) has decided to reduce interest rates, which would not be very beneficial for those depositing money into banks, but it would benefit business investments as lending rates would follow the reduction as well, which would ultimately stimulate growth. Although the policy aims to benefit India’s long-term political and economic stability, the short term consequences come at a disadvantage to the average citizen.

The loss of 3 lack crore rupees will lead to nearly a 17% decrease in the base money supply. This decrease in the money supply will directly lead to a reduction in the aggregate demand. Subsequently, this would lead to a reduction in the price level of the economy, and therefore inflation, but would leave output unchanged. The reduction in money supply will put deflationary pressure on the rupee. Modi hopes that this reduction in inflation rates along with the reduction in interest rates by the SBI will be enough of a stimulus for growth and increased output to make up for the lost currency.

The demonetization policy, although well-intentioned, unnecessarily harms the lower-income groups, especially the rural population, who are often paid in 500 and 1,000 rupee notes. Many rural citizens have found the policy incredibly difficult since India’s cash economy is such an integral part of the market, and the lack of these two notes has thrown the economy into turmoil. 52-year-old laborer, Prashuram, says, “It was like someone had picked [his] pocket”, in reference to the ban since majority of his income was in 500 and 1,000 rupee notes. Citizens like Prashuram went days without sufficient means of payment for food, transportation, and other such goods and services. Although people were able to exchange their notes for legitimate notes, it took 6 days to reconfigure the 220,000 cash machines around the country to dispense the new 500 and 2,000 rupee notes. Furthermore, lines outside banks and ATMs grew up to the 100’s, leaving people waiting in line for hours before they could access cash. In Delhi, Mumbai and Bangalore, Starbucks started giving out free coffee to the people waiting in queues outside ATMs.

The ban was effective immediately with a 3-day exception for hospital bills and airline tickets. All other transactions must require appropriate forms of payments that do not include the 500 and 1,000 rupee notes. The time lag of printing new, legitimate notes has proven to be very problematic for the government. As a result, people’s purchasing power has dramatically reduced, enraging a large number of the population, mainly low-income laborers who had previously received their payments through cash. European countries, as well as the United States, have also previously considered removing large notes from circulation. However, for them, the costs far outweigh the benefits due to the low levels of corruption that are incomparable to that of India’s.

The ethics of the policy can be heavily debated. One might argue the policy to be unethical, since it harms millions of hard-working Indians who have made their money legitimately. They should not have to suffer as a result of elitist corruption. However, one could also argue that the long-term benefits far outweigh the short-term negative externalities. What most fail to realize is that in an economy with such high levels of corruption, a gradual demonetization policy would be ineffective, since the corrupt officials would be able to find their way around it quite quickly. With the ban being effective immediately, there is no time for corruption to weave its way around, and will therefore be more successful in exterminating corruption altogether. India’s political stability has always been threatened by its corruption. Eventually, when the ban eliminates “black” money from circulation, corrupt officials will no longer have the financial power they previously had, and the Indian government will be able to move forward in tackling poverty, hunger, bad healthcare and infrastructure more efficiently.

Prime minister Modi has faced heavy criticism, both domestically and internationally, as a result of the ban. In the past, countries who have demonetized notes have resulted in social uprising and discontent, including Burma, former Soviet Union and North Korea. Critics expected Modi to give some warning to the Indian population to prepare for the ban due to patterns of previous consequences in other countries. However, proponents of the ban argue that the element of surprise is more effective in eliminating corruption. Further, although the ban inconveniences citizens in the short run, any form of legitimate income will eventually be exchanged for legitimate cash. Only time will tell whether or not the long-term benefits outweigh the short-term consequences.

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