Demonetisation : Benefits and Costs associated with it

On 8th November, 2016 at the stroke of midnight, the government of India demonetised the two largest denomination currency notes in circulation i.e. notes of rupees 1000 and rupees 500. By this step, 86% of the currency in circulation ceased to be a legal tender except for some purposes like payment in hospitals. These notes were to be deposited in the banks by 30 December, 2016. Moreover, restrictions were placed on the cash withdrawals from banks and ATMs.

Aims of this action stated by the government

1. Curbing corruption
2. Curbing counterfeiting
3. Curbing the use of high denomination notes for terrorist activities
4. To recover black money

When the government realised that it was somewhat slow on the above objectives, its changed the narrative of demonetisation as a step towards cashless economy.

Benefits of demonetisation

• Tax on Black money
• Those who has black money had the following choices :
1. declare their unaccounted wealth and pay taxes at a penalty rate 
2. continue to hide it, not converting their old notes and thereby suffering a tax rate of 100% 
3. launder their black money by paying a cost for converting the money into white 
• As per the Economic Survey, there was active money laundering. But in all the above choices, black money hoarders did suffer. Moreover, bank accounts are still being screened for suspicious transactions, which means that those who engaged in laundering run the risk of punitive taxes and prosecution, in addition to the fees or taxes already paid.
• The demonetised currency that has not returned decreases the liability of RBI and hence increases its net worth. In this sense, demonetisation has effected a transfer of wealth from holders of illicit black money to the public sector.
• Move towards cashless economy
• With large denomination removed, the public began to shift towards digital payment technologies. It increased digital literacy.
• It would also improve tax compliance since most of the black money is generated because of cash transactions. As per Watal Committee, cash payments account for about 78% of all consumer payments in India.
• It brought people into the formal economy, thereby increasing financial saving and reducing tax evasion.
• The government has taken some steps to facilitate digital transactions like launch of BHIM(Bharat Interface for Money) app which has enabled inter-operability of digital transactions and launch of Aadhaar Merchant Pay which allows anyone with just and Aadhaar number and a bank account to make merchant payment using his biometric identification. Government has also reduced Merchant Discount Rate (MDR).

• Brought money into the formal financial system
• The money in the form of cash which was lying idle was brought into the financial system. This money can be lent by banks to build the economy or infrastructure.
• But it needs to be seen if this money is withdrawn once the limits on cash withdrawal are removed. As per RBI, most of this money would be withdrawn once the limits on cash withdrawal are removed.
• Real Estate
• Most of the black money in invested in real estate.
• Real estate prices have fallen since demonetisation. It would lead to affordable housing.

Costs of demonetisation

• Impact on GDP


• Since a lot of transactions in India happen in cash, demonetisation affected the small scale industries and informal sector.
• As workers in the informal sector have been laid off, they have bought fewer goods and hence it has affected formal sector has well.
• As per the economic survey, economic activity has been affected adversely but temporarily by demonetisation. Therefore real GDP growth in 2017-18 is expected to be in the range of 6.75 - 7.5  percent range.
• Inconvenience to public
• There were reports of huge queues outside banks and ATMs.
• There were cash shortages. People had problem in running their businesses and day to day functions.
• Costs of printing new notes and recalibrating the ATMs for new notes
• Loss of bank man power to assist in remonetizing the economy
• Cost of sterilising the surge in liquidity though Market Stabilisation Scheme.

Costs associated with demonetisation are short term, but it may have long term benefits. Emphasis should be on maximising the benefits and reducing the costs. The windfall gains from unreturned currency should be used in capital expenditures rather than revenue expenditures. The push provided to digitisation must continue.