The government made a big move in the fight against black money last night. Even though this move will create currency chaos, by taking Rs. 500 and Rs. 1000 notes out of circulation, the Modi government has in effect hit the reset button. We take a look at the details of the policy change and its impact on the economy and the markets.
The government has decided to take existing 500 and 1000 Rupee notes out of circulation. These notes will now cease to be legal tender, effective from midnight last night. Citizens would have to exchange their notes at banks or the post office for new currencies in the form of a new 500 and 2000 Rupee note. The government has cited that this move is an attempt to curb the circulation of fake notes and to reduce the incidence of black money. The RBI has also released an FAQ on this new scheme, to give the public more details of the scheme.
The reason that this is such a power move against black money, is that in one stroke the government has denoted all existing high value currency as no longer legal tender. This means that anybody who holds such notes will be forced to change their money at the banks. Otherwise their existing currency will become worthless. And because all deposits will have to be done in bank branches, the government will be able to monitor large cash transactions and question the source on money. This move will thus force increased tax compliance and give a big push for the bringing the parallel economy into the formal one.
According to the Mint Paper, this is actually the third time in India’s history when such a scheme has been introduced. The first was in 1946, when Rs. 1000 and Rs. 10,000 notes were withdrawn and reintroduced in 1954. The second was in 1978, when the Janta Party coalition government took Rs. 1000, Rs. 5000 and Rs. 10,000 notes out of circulation. It is very interesting to note that the ordinance in the 1970s was done for the same reason it is being done today; which is to remove black money from the system.
But if the 1978 ordinance was not successful, why would this time be any different? According to the article, the decision to withdraw high-denomination notes, seldom produces striking results. The reason for this is that people who make their money from graft rarely keep their money in the currency. Despite the media frenzy on money stashed in gunny bags and suitcases, bulk of such money is stored in physical assets like real estate and gold. In effect, this change will have the biggest impact on the “cash hoarder” rather than the entire black economy. Still a hard reset of the currency will give a chance to clean up the existing system. Once the new notes come in, cash generation and the black money cycle will again restart, but this is an important step to “clean out the cupboard”.
One major difference between the current measure and previous attempts is the fact that today KYC and identification checks are quite stringent. This ensures that any money that does come into the system can be tagged to a person and so will help to formalise our economy and accelerate the move toward a cashless economy.
According to Bloomberg Quint, out of 16.4 lakh crore rupees in circulation, roughly 86% is in 500 and 1000 Rupee notes. Moreover, according to Business Line, 98 per cent of consumer payments — at retail outlets, to small service providers, etc — are in cash, with the ₹500 note as the default base denomination for most transactions. In a very short time of 50 days, this large amount of cash will have to be returned to the RBI and reissued as new currency. This is going to be a logistical and administrative headache for the banks and the government and will likely lead to a huge cash shortage in the market.
The government and the reserve bank are also limiting withdrawals and exchange of cash and are instead encouraging these funds to stay in the banking system. The use of cheque, card and electronic means are freely available to use. Even though Urjit Patel has said that there should be no impact on liquidity in the system, the shortage of cash over the next few months will likely subdue economic activity and growth in the near term, with the consumption sector being particularly affected.
According to a report by Ambit Capital, India’s black economy is estimated at at over Rs 30 lakh crore or about 20 per cent of total GDP. A majority of this money is locked up in real estate and gold. The article suggests that more than 30 per cent of India’s real estate sector is funded by black money. The new rules around real estate regulation have already caused land prices to come down and this new change is likely to further tighten the noose around black money in the sector. This is going to be a very painful transition, but will lead to a much healthier and transparent real estate market in the long term.
There is also the secondary effects to contend with. The cash crunch will likely lead to a falling equity market and when we combine this with falling real estate values, we see the wealth effect causing consumers to cut down on purchases. Additionally sectors which are exposed to huge cash payments, such as the medical profession or kirana shops or tuition teachers, will see a slowdown affecting incomes and wages.
However, this move is hugely positive in the long run for the Indian economy. This move will help formalise our economy and leave us with a more transparent system. Financial inclusion and banking will get a huge fillip and as a result money will become more productive in the economy. The government will also get a big boost because more money will come into its coffers from previously undeclared sources and from increased taxation. This will also help it spend more on its development agenda or on subsidies. Finally, it will also accelerate the shift toward a cashless economy.
Rishad is the founder of Kairos Capital. He started his career with Standard Chartered Wealth Management and has extensive experience in markets, particularly in terms of mutual funds and stocks.