DEFINITION of 'Demonetization'

Demonetization is the act of stripping a currency unit of its status as legal

tender. It occurs whenever there is a change of national currency: The current form
or forms of money is pulled from circulation and retired, often to be replaced with
new notes or coins. Sometimes, a country completely replaces the old currency with
new currency.

The opposite of demonetization is remonetization, in which a form of payment is

restored as legal tender.

BREAKING DOWN 'Demonetization'

There are multiple reasons why nations demonetize their local units of currency:

to combat inflation
to combat corruption and crime (counterfeiting, tax evasion)
to discourage a cash-dependent economy
to facilitate trade
Dramatic Examples of Demonetization
The Coinage Act of 1873 demonetized silver as the legal tender of the United
States, in favor of fully adopting the gold standard. Several coins, including two-
cent piece, three-cent piece, and half dime were discontinued. The withdrawal of
silver from the economy resulted in a contraction of the money supply, which
subsequently led to a five-year economic depression throughout the country. In
response to the dire situation and pressure from farmers and silver miners and
refiners, the Bland-Allison Act remonetized silver as legal tender in 1878.

An example of demonetization for trade purposes occurred when the nations of the
European Union officially began to use the euro as their everyday currencies in
2002. When the physical euro bills and coins were introduced, the old national
currencies, such as the German mark, the French franc and the Italian lira were
demonetized. However, these varied currencies remained convertible into Euros at
fixed exchange rates for a while to assure a smooth transition.

In 2015, the Zimbabwean government demonetized its dollar as a way to combat the
country�s hyperinflation, which was recorded at 231,000,000%. The three-month
process involved expunging the Zimbabwean dollar from the country�s financial
system and solidifying the U.S. dollar, the Botswana pula and the South African
rand as the country�s legal tender in a bid to stabilize the economy.

India's Demonetization
In 2016, the Indian government decided to demonetize the 500- and 1000- rupee
notes, the two biggest denominations in its currency system; these notes accounted
for 86% of the country�s circulating cash. With little warning, India's Prime
Minister Narendra Modi announced to the citizenry on Nov. 8 that those notes were
worthless, effective immediately � and they had until the end of the year to
deposit or exchange them for newly introduced 2000 rupee and 500 rupee bills.

Chaos ensued in the cash-dependent economy (some 78% of all Indian customer
transactions are in cash), as long, snaking lines formed outside ATMs and banks,
which had to shut down for a day. The new rupee notes have different
specifications, including size and thickness, requiring re-calibration of ATMs:
only 60% of the country�s 200,000 ATMs were operational. Even those dispensing
bills of lower denominations faced shortages. The government�s restriction on daily
withdrawal amounts added to the misery, though a waiver on transaction fees did
help a bit.

Small businesses and households struggled to find cash and reports of daily wage
workers not receiving their dues surfaced. The rupee fell sharply against the
dollar.

The government�s goal (and rationale for the abrupt announcement) was to combat
India's thriving underground economy on several fronts: eradicate counterfeit
currency, fight tax evasion (only 1% of the population pays taxes), eliminate black
money gotten from money laundering and terrorist-financing activities, and to
promote a cashless economy. Individuals and entities with huge sums of black money
gotten from parallel cash systems were forced to take their large-denomination
notes to a bank, which was by law required to acquire tax information on them. If
the owner could not provide proof of making any tax payments on the cash, a penalty
of 200% of the owed amount was imposed.

Alternative Funds
Soon after the announcement, people rushed to buy gold, a demand that drove prices
up, in some cases even to a 60% premium, prompting the tax authorities to conduct
surveys, according to the Business Standard newspaper. The government emphasized
the need to furnish PAN (Indian Permanent Account Number) card details on purchases
for accountability purposes, and many jewelry shops that were flouting the norms
came under crackdowns. Simultaneously, rumors of a gold ban started to float, which
led to agencies ramping up the volume of gold imports � to around 100 metric tons
during November, the highest since 2015, as reported by Reuters.

Many Indians switched to alternative payment avenues � a big deal in a country of

1.2 billion with only 25.9 million credit cards and 697 million ATM cards as of
July 2016. The biggest gainers were mobile wallet companies that offer ease of
transactions through a large network of partners. Alibaba (NYSE:BABA)-backed Paytm
saw a sevenfold increase in overall traffic and a 10-fold jump in money added to
Paytm accounts. It also saw the number of transactions double to five million a
day. App downloads for Paytm increased by 300%. Paytm rival MobiKwik also saw its
app downloads quadruple and a 20-fold increase in money added to the wallets,
MobiKwik Founder & CEO Bipin Preet Singh, told CNBC-TV18 on November 13.

Prepaid cash cards were another option that customers found useful, and that meant
good news for companies like ItzCash. Other alternatives include mobile payments
systems linked to e-commerce businesses like Ola Money, FreeCharge, Flipkart
Wallet. Ola Money, the payment portal for popular transportation app Ola Cabs,
reported a 1500% jump in money added to the accounts in less than four hours.

Interest in Bitcoin also spiked: Sandeep Geonka, co-founder of Zebpay, told

Investopedia that his bitcoin exchange was now adding about 50,000 new users per
month. "We are seeing an increased demand for bitcoin and India clearly has
shortage of supply, making the demand and lack of liquidity push up prices of
bitcoin as compared to global exchanges,� said Coinsecure CEO Mohit Kalra. The
virtual currency was trading at INR 55,735 in India in November (about $836),
compared INR 47,725 (about $712) (Coindesk) elsewhere.

Long-Term Effects
Over 3 trillion rupees, or over $44 billion in old currency, was deposited with
Indian banks in just the first week after the demonetization. There was concern
that the uncertainty and short-term liquidity squeeze would take some momentum off
the Indian economy, the fastest-growing in the world; in particular, sectors like
real estate, notorious as a harbor for cash dealings and black money, were expected
to take a hit, with "luxury property prices dipping by as much as 25-30%," said
Ashwinder Raj Singh, CEO of Residential Services, JLL India.

But experts believed any slowdown would only be short-lived once the systems
adjusted to the new normal, especially if the government heeded calls to lower
interest rates by groups like the Federation of Indian Chambers of Commerce and
Industry (FICCI). Credit rating agency India Ratings & Research maintained its GDP
growth forecast for India at 7.8% for FY17, albeit with a downward bias.

The possible purposes of demonetization are as follows:

Since 2009, the currency to GDP ratio in India had gradually increased from 1 : 9
to 1 : 12 which is not a good sign for long term health of the economy. By
demonetizing 85% value currency notes government got an opportunity to correct it.
97% of the transactions in India were effected in cash, i.e. were not getting
routed through any bank. Huge cash hoarding shrinks bank deposits and lending
capacity of the commercial banks which leads to higher interest rates.
A few businesses like land dealers, real estate dealers, promoters and builders,
goldsmith, jwellers, foreign currency dealers, private money lenders generally hold
huge amounts of unaccounted money in form of currency notes. Such money had created
a parallel economy in India. Such money has become void or have reached bank
accounts through direct or indirect channels.
More and more cash-less or less-cash transactions will lead to routing of
consideration in bank thereby the more and more income will get disclosed and
declared which will increase the direct tax collections.
Number of income tax payers will increase,
Pockets and persons where black money gets generated can be identified.
As the share of direct tax collections increase government will be in a better
position to rationalize the indirect taxes which will create social justice.
The fake currency notes circulating in the economy required a surgical attack.
Demonetization has converted those fake currency notes in pieces of papers.
Obviously there is bound to be some political reasons to reap advantage. These
could include the elections in UP, Uttranchal, Punjab, Goa and the Mumbai
Municipality. This decision has dried out the treasury of the apposition parties so
they will not able to meet expenses related to assembly elections.

Impact of Demonetisation on the Economy

On GDP Growth
India�s GDP which grew at 7.6% in FY 2015-16 is likely to slow down by 0.5% to 1.5%
as per reports of various agencies. This is is due to less availability of cash in
cash-intensive sectors like manufacturing and real estate. Even the automobile
industry which was growing rapidly earlier has seen a contraction in the October-
December quarter of 2016. Purchasing power of consumers has been negatively
affected due to cash not being readily available.

We need to remember that Indian economy is largely cash driven with more than 90%
transactions taking place in cash and digital transactions accounting for just the
remaining 10 percent.

Banks have also been focusing on the single task of deposit and withdrawals with
the result that their core function of issuing loans has been adversely affected.
Also current account customers, who are largely business owners, need large amounts
of cash at short notice have not been able to access cash and credit owing to
restrictions on withdrawals and inability of banks to focus on the task of issuing
loans.
On Tax Compliance
India�s tax-to-GDP ratio is quite low at 16.6% compared to other emerging
economies. It is estimated that since more money, including black money, gets
accounted for this will lead to better tax compliance owing to better targeting of
income. The positive impact could be lower tax rates as the tax base widens and
more people start paying taxes. The digital push of the government will also result
in higher indirect tax revenue for the govt. in the form of service tax. Moreover
businesses that under-reported their revenue earlier, will have to make proper
disclosure, especially, of revenue received through digital or cashless means.

On Small and Medium-sized Enterprises (SMEs)

The small and medium-sized enterprise (SME) sector, as we understand, is a big
chunk of the economy, contributing to eight percent of the GDP whilst employing
more than 80 million people year on year.

The labour wages in this sector are largely paid in cash and wages have been
adversely affected by the demonetisation move. Unemployment has also been reported
owing to decline in demand of SME goods as the purchasing power of the consumers
has contracted in the short term. Other sectors within the SME space like
restaurants and transport operators have also been negatively impacted since
economic activity has declined and also due to the fact that there is high tendency
in this segment to accept payments through cash only.

Wholesale vegetable markets have been witnessing declining demand and prices of
tomatoes and other food items have fallen drastically making it economically
unviable for the farmers to produce these crops. Which takes us to the next point.

On Agriculture
This is one sector where all transactions are in cash and, given the values
involved, involve the higher denomination notes. The withdrawal of the old currency
notes has put pressure on the mandis; farmers are having problems in selling their
produce as both the parties have to agree on the mode of payment. Also since there
is acute shortage of Rs 500 denomination notes presently, change for the high
denomination Rs 2000 notes is not readily available with the vegetable and fruit
vendors. This is also taking the buyers away from these vendors to big retail
markets thus impacting the livelihood of the unorganised sector.

On Employment Generation
Since consumer demand has slowed and consequently industrial production has
declined, employment generation has been adversely impacted by the currency
demonetisation drive. Since the manufacturing sector which accounts for the highest
employment of skilled and semi-skilled labourers, is witnessing slowdown in
production; not only less jobs are being created but lay-offs are also taking place
at a higher rate.

As per this report, Industry is staring at temporary job losses due to

demonetisation, as production gets hit, especially in labour-intensive sectors like
textiles, garments, leather and jewellery. As many as 4 lakh people, mostly daily
wagers, may have either lost their jobs or shunned work temporarily due to the lack
of payment so far, and the number is only going to grow if the cash crunch
persists.

Impact of Demonetisation on Black Money

As outlined in the first post on What is Demonetization of Currency, fighting black
money rampant in the economy was one of the foremost objectives of this entire
exercise and we will discuss in detail whether this objective was realised or not.

If you read the above post, you will know that cash component forms just 6% of the
black money in the Indian economy and currency demonetization will target just this
6% black income. If various reports are anything to go by, most of this black
income has been converted into white by depositing it in Jan Dhan accounts,
depositing in individuals own accounts by breaking into smaller chunks, by
exchanging for new currency notes through hawala dealers, by buying last-minute
luxury items like jewellery and high priced mobiles, by paying advance wages to
employees etc.

This is supported by the fact that almost the entire amount of Rs 14.18 lac crores
in Rs 500 and Rs 1000 currency denominations lying with the public has returned to
the banks at the time of writing this post. This implies that the dividend which
the govt. has been hoping for by way of 2-3 lac crores not returning to the banking
system (since it is black money and/or counterfeit currency) has turned out to be a
mirage.

Also as per various announcements by the govt. from time to time that deposits by
housewives and those exempt from tax will not be scrutinized has provided a way out
for black money hoarders to convert their money into white.

However there have also been some positive impacts like one time removal of
counterfeit or fake currency from the economic system. Some people argue that since
black money has reduced, prices of black money intensive sectors like real estate
and gold jewellery will go down. This remains to be seen.

But demonetisation cannot and will not prevent future generation of black money
since black money problem is more of a cultural mindset in India than a legal
problem.

It will also be easier for the corrupt and black money hoarders to deal in Rs 2000
currency notes as compared to Rs 500 and Rs 1000 notes since higher currency value
can now be carried with greater ease.

A total of Rs 3185 crores in black money of which Rs 86 crores in new notes has
been seized by the Income Tax authorities since the launch of the demonetisation
drive on 8th November. This implies that on the one hand black money is getting
unearthed and on the other leakage of new currency notes is taking place; most
probably through the banking system itself.

Impact of Demonetisation on Terror Funding and Fake Currency

This was another stated objective of the currency demonetization drive of the
government. While initial reports suggest that terror related activities in J&K
witnessed a noticeable halt in the days following the demonetisation drive,
including, stone pelting by misguided youths; the recent Nagrota attack shows that
terrorism is continuing in the valley. Although the availability of cash has surely
declined among the terror groups presently.

The govt. also claimed that the new currency notes contain very high security
features and are almost impossible to replicate. But this claim does not seem to be
true since many stories of counterfeit currency have come to light since the note
ban was announced on November 8th. However in the short term, circulation of fake
currency has definitely slowed down considerably since the infrastructure set up to
print fake currency notes in neighbouring countries like Pakistan has been rendered
useless by the demonetisation drive.

Impact of Demonetisation on Cashless Transactions

As already explained above that cashless transactions account for only 10% of all
transactions on daily basis. The government in order to divert some of the blame
for the poor implementation of this demonetization exercise announced mid-way that
making India a cashless or less cash economy was one of the important objectives of
this demonetization drive. Towards this end, the Finance ministry, RBI and NITI
Aayog announced a host of incentives to boost cashless transactions. This was also
done to ease some of the problems that have resulted due to acute shortage of cash
in the economy.

Some of these incentives include:

No Service Tax on cashless transactions below Rs 2000

Providing cash backs ranging from 0.25-0.75 percent on various transactions like
paying for fuel, govt utility bills, stamp papers, property registrations etc.
Encouraging use of Point-of-Sale (PoS) machines and mobile wallets like PayTM by
businesses and individuals
Reducing self-assessment tax from 8% to 6% on businesses with annual turnover of
less than Rs 2 crores
Announcing monthly jackpots for people using cashless transactions in govt services
And other incentives
As a result, use of mobile wallets and cashless transactions, as a whole, has
increased by about 300% since the launch of demonetisation exercise. However we
need to remember that this 300% increase is against a very low base of digital
transactions and most of this increase has been noticed in the urban areas where
people have ready access to PoS machines, internet banking, and mobile wallets.

Cashless transactions are still rarely used in rural areas and in the informal
sector like road side vendors, small shops, buying seeds, wage payments etc

Below are some effects of demonetization in India:

1. The impact of demonetization on the retail market.

The Indian retail section generates a lot of cash transactions, there might be a
decrease in the sales and purchases for the next two quarters.
Moreover, the effect is felt more by the small traders and the unorganized retail
section, as opposite to the organized retailers.
The impact can be seen on few sectors like jewels and automobile; undoubtedly it
will take some time to recover. However, the use of plastic currency and online
transactions will keep on releasing the money into the retail market.
2. The Impact of Demonetization On Stock Market:
The stock market in India have fallen a bit more in comparison with emerging Asian
markets. The stock market has fallen by 3.8%, such fall is higher than other
emerging Asian markets.
The Sensex is compromising large companies which might be affected as much by the
step of demonetization. Bombay Stock Exchange�s mid and small caps indices have
fallen by 6%. The significant impact of the demonetization will be in the
unorganized sector which isn�t reflected in the markets.
3. The Impact of Demonetization On Banking Sector:
As the banks and the financial institutions get a lot of cash in their hands, they
will start lending money to the public at lower interest rates. Consequently, the
interest rate on borrowings will fall. Moreover, as the CASA (Current Account
Saving Account) increases, now the banks won�t be requiring any other means of
getting the money (either in form of loan from RBI or from other commercial banks).
4. The Impact of Demonetization on Real Estate Sector:
Demonetization has likely reduced the demand and adversely hit the prices in the
real estate sector. Property prices are going to fall by not less than 10-15% due
to the unexpected move of demonetization. However, the augmented liquidity in the
banks will attract genuine buyers or investors to invest in real estate sector.
5. Impact of Demonetization on Indian Economy:
Removal of two highest denominations available in India will probably hit the
economy in the short run. The service sector, which dominates the economy and
includes a major chunk of cash transactions will likely to hit the hardest.

Conclusion
Demonetisation of old currency notes surely has had some positive impact like
reducing the cash flow to terror organisations, dismantling of counterfeit currency
infrastructure, better income tax and indirect taxation, boost to digital economy.
However, it has come at a huge social and economic cost. Sandeep Dongre writes that
demonetization costs are estimated at Rs 1.28 lakh crore to the economy for the 50-
day time period till the end of depositing period of old currency. This includes a
cost of Rs 17,000 crore towards the government and the RBI for implementing the
demonetisation process in India.

Demonetisation is a one-time event and will not have much long term effect. It
alone is not sufficient to counter black money and corruption in the country;
rather other measures are more crucial like bringing the offshore tax evaders to
book whose names figure in the Panama papers, raid on benami properties, making
donations to political parties open to public scrutiny and making it mandatory for
all donations above Rs 2000 to political parties and religious places to be through
digital means only.

This entire exercise seemed more like a carpet bombing than a surgical strike where
the vast majority of honest and law abiding citizens had to undergo terrible
hardships in order to catch the few black sheep who have hoarded black money and
who also managed to convert their black income into white.