Indian Government Invalidates Large Currency Denominations — Could This Affect the Nation’s Liquidity and GDP?

Published on 11 Nov, 2016

Indian Currency Invalidation

Remember remember
The 8th of November
A bid to foil terror was plot
With scant hours to midnight
The government done did right
A mortal blow to the shadow they wrought.

A bold move by the country’s government to weed out fake currency in the interest of national security, the decision could have far-flung ramifications for the country’s ‘shadow economy’. 

The government’s objective in invalidating existing Rs500 and Rs1000 denomination currency notes overnight seems like a bid to tackle both fake currency in circulation as well as the “black money” that’s out there. These denominations make up approximately 86% of the Rs17.8 trillion (hard currency) in circulation, and analysts estimate between one-third and half of that is money without a proper paper trail. That’s probably why there’s been a mad scramble overnight to convert older currency by way of jewelry purchases, filling up on fuel and advance payments of bills, among other things.

The overnight overhaul limited citizens’ ability to convert their old notes into new ones en masse; it’ll also allow the government to track large deposits and identify unusual (read less than legal) concentrations of wealth. The new currency that will replace existing notes will also allow the government to easily track the ebb and flow of the country’s hard cash, resulting in a greater degree of accounting (and due tax revenues) during commercial transactions.

India’s cash (or shadow) economy will be impacted significantly, at least immediately.


How Much of India’s “Black Money” Will Surface Before December?

The estimated size of India’s “parallel” economy varies widely, pegged anywhere between 20% to 50%+ of India’s GDP.

Even conservative estimates of 20%-30% mean it’ll be worth anything between US$400–600 billion, at a gross domestic product (GDP) of US$2 trillion.

Some of this off-grid economy should come clean over the next month.

Even if ~10% of India’s shadowy parallel economy is eventually accounted for, it could mean the addition of ~US$40–60 billion to India’s GDP in the long term.


Could Liquidity in India’s Monetary System Go Up?

India’s money supply (M3) was US$1.86 trillion in October 2016.

An additional US$40-60 billion would translate to a ~2-3% increase in the nation’s money supply.

Most of this increase would be among savings and current accounts. The increase will most likely be a short term spike due to money (in the form of Rs500 and Rs1000 currency notes) being replaced and deposited in banks.

Considering that the country’s money supply rate increased just ~1 per cent in October this year, the liquidity boost may spike India’s M3 supply.

A more liquid market would also bring down wholesale money market rates in the short term, thereby providing relief to banks in terms of cost of funds. A receding tide due to withdrawals of deposits — most of which were likely due to obligatory procedures when exchanging invalid currency notes — could however, ebb the surge in liquidity.


How Much Will This Impact India’s GDP?

With a boost of US$400-600 billion India’s GDP could rise by 20%!

Realistically however, even if 10% of India’s unaccounted for economy goes legit, the additional US$40-60 billion would boost the GDP growth rate by 2%-3% for a quarter or two.

This will come later however; consumption will likely be hit in the near term.

Apart from larger industries such as real estate, gems and jewelry, automobile (especially high-end vehicles), several other sectors such as offline retail, construction (ex-real estate), small and medium enterprises may be affected far more negatively.


Is Demonetization the Final Play, or is There More to Come?

After Tuesday’s surprise announcement by Prime Minister Narendra Modi, the government did a double tap with another significant announcement on Wednesday.

If deposits made (by individuals) between November 10 and December 30 exceed Rs250,000, their finances will be scrutinized by the Indian Income Tax Office to ensure they’ve properly declared their income.

Of course.

We should have seen it coming.

The government has been systematically setting up the building blocks of a cashless economy.

Two years ago, the government rolled out the Jan Dhan Yojana, opening ~255 million new bank accounts since then, predominantly for the benefit of the economically weak stratas of society. The government had also issued 194 million RuPay cards by the end of October, 2016.

In April this year, the then RBI governor Raghuram Rajan and Nandan Nilekani announced the “Unified Payment Interface”, or UPI, a platform that’ll allow any and all Indians to use mobile phones to transfer money and conduct small transactions using their bank accounts.

India’s Prime Minister Narendra Modi persuaded listeners to stop using cash in a radio address to the nation in May.

In July, a Special Investigative Team appointed by the Supreme Court boldly recommended that cash transactions above Rs3 lakhs (~US$4,500) be banned and no one should be allowed to hold more than Rs1.5 million in cash.

The RBI has set up a joint committee with a directive to find ways to reduce the cost of transacting using credit cards (2% for each purchase right now) for consumers.

The government announced the tax amnesty scheme (which closed in September) and unearthed ~ Rs 65,000 crore of undisclosed income, collecting ~ Rs 29,000 crore in taxes.

All these steps, in context, seem to be firm steps toward an economy that’s more organized, transparent, and accountable.

While current endeavors to purge the economy have already created quite some furor, there could be more in store.

Another amnesty scheme perhaps, or more devious ways to unearth the country’s unscrupulous undisclosed assets.

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