Note demonetisation: 86% of Indian currency has been frozen overnight

While Tuesday’s announcement by Prime Minister Narendra Modi that the Reserve Bank of India was going to demonetise existing Rs 500 and Rs 1,000 currency notes has been universally termed as unexpected, the surprise element was integral to fulfilling the intent of the move – a direct attack on black money.

The move was also termed as unprecedented by some, but this isn’t the first time the RBI has demonetised currency. Rs 1,000 and Rs 10,000 banknotes were demonetised in January 1946. These two denominations were reintroduced in 1954 along with currency notes of Rs 5,000, and all the three were again demonetised in January 1978.

More recently, in 2014, the RBI had demonetised all banknotes printed before 2005.

After facing flak even from his own biggest supporters for not keeping the 2014 electoral promise of bringing back all the undeclared funds stashed abroad, Modi had given enough indications that he meant business on the question of tackling black money in the country.

Talking about the Income Declaration Scheme, which ended on September 30, 2016, Modi had been quite forthright:

“For all those who are still willing to come in the mainstream, I have said this in public that 30th of September is your last date. You may have made mistakes with whatever intentions. Whether it has been done willingly or unwillingly, here is your chance. Come into the mainstream…no one should blame me if I take tough decisions after the 30th Sept.”

Eventually, more than Rs 65,000 crore was declared under the scheme, which is expected to yield tax collection of Rs 29,400 crore.

But despite such warning signs, the move to demonetise came as a shock, particularly given how common Rs 500 and Rs 1,000 notes have become in daily lives. To put things in perspective, these two denominations account for a whopping 86% of all banknotes in circulation, as per the RBI’s Annual Report for the financial year 2015-'16.

India’s real Gross Domestic Product at constant (2011-'12) prices for the year financial year 2015-'16 stood at Rs 113.5 lakh crore, indicating that Rs 500 and Rs 1,000 banknotes accounted for nearly 12% of India’s GDP, showing how integral these banknotes are to India’s economy.

What accounted for this move was the rapid rate at which these notes have grown in circulation in the last five years – the Rs 500 notes by 76% and the Rs 1,000 notes by 109% over the 2011 numbers, said Economic Affairs Secretary, Shaktikanta Das on Tuesday.

There had been various recommendations for banning notes of higher denominations in the recent past. In July 2016, the fifth special investigation team in its report to the Supreme Court made the following recommendations:

Cash transactions: The SIT has felt that large amount of unaccounted wealth is stored and used in form of cash. Having considered the provisions which exist in this regard in various countries and also having considered various reports and observations of courts regarding cash transactions the SIT felt that there is a need to put an upper limit to cash transactions. Thus, the SIT has recommended that there should be a total ban on cash transactions above Rs. 3, 00,000 and an Act be framed to declare such transactions as illegal and punishable under law.

Cash holding : The SIT has further felt that, given the fact of unaccounted wealth being held in cash which are further confirmed by huge cash recoveries in numerous enforcement actions by law enforcement agencies from time to time, the above limit of cash transaction can only succeed if there is a limitation on cash holding, as suggested in its previous reports. SIT has suggested an upper limit of Rs. 15 lakhs on cash holding. Further, stating that in case any person or industry requires holding more cash, it may obtain necessary permission from the Commissioner of Income tax of the area.

Given the number of people this move will directly affect, there is bound to be chaos and disruption in the following days and weeks. But Modi pitched it as a "fight against corruption, black money, fake notes and terrorism" and expressed confidence that "every citizen will stand up and participate in this mahayagna".

"Terrorism is a frightening threat. So many have lost their lives because of it. But have you ever thought about how these terrorists get their money? Enemies from across the border run their operations using fake currency notes."

The RBI and government will need a massive outreach and communication program to calm the frayed nerves of the common citizen and transition to the new currency notes.

Long-term benefits

Apart from disrupting daily lives of the common citizen, there are even bigger implications for the economy as a whole. India has a vibrant and thriving parallel economy that survives purely on cash. There are no reliable estimates of the size of this parallel economy, but the sheer number of Rs 500 and Rs 1,000 notes is indication enough of its importance.

Politics and various elections are known to run on cash. Same is the case with sectors such as real estate. The rural areas in particular, which do not have formal sources of banking, also deal largely in cash. Unorganised labour, including in urban households, such as domestic workers and drivers, are paid in cash, and mostly in these denominations.

It is too early to even imagine the impact on all sections of society and parts of the economy, particularly if we factor in savings by housewives, for example. It is not known how money saved out of income that has been paid tax on will be distinguished from unaccounted or "black money".

The advantages of this move, though, will be felt only in the long-term. While formal modes of payments such as debit and credit cards, net-banking and digital wallets should get a boost, this will take a long time to be felt simply because the proliferation of these products is still low among the middle classes and the poor, for whom cash is still the predominant mode of transactions.

The government’s move is bold in its intent and massive in its measure. Arguably, this is Modi’s biggest move since he was elected prime minister. While the intent is clear, the implementation and impact is yet to be seen. One thing is sure though – the Indian economy just had a massive disruption overnight.