News accounts and analyses on other blogs have usefully described and critically assessed the “demonetization” shock that Prime Minister Narendra Modi gave the Indian economy on November 8. Here we emphasize two features of Modi’s initiative that have been little noticed. First, the combination of demonetization followed by “remonetization” will transfer billions worth of US dollars from the Indian public to the Indian government. Second, the skewed pattern in which new notes will be injected will favor some sectors over others.

Background

To recap, Modi announced that, in order to fight untaxed “black money” holdings, the two highest denomination rupee notes would be demonetized the next day (the Rs. 500 and Rs. 1000, worth about $7.50 and $15). Indian citizens have some weeks to deposit the invalidated notes into banks for deposit credit, or exchange them for new valid notes of Rs. 500 and Rs. 2000. But the exchanges can only be made in small amounts (Rs. 2000, or $30, per person per day) for the time being and, as Devangshu Datta points out, “only with identity proofs (which hundreds of millions don’t have) and the additional hardship of standing in many queues for many hours.” Once a greater volume of new notes becomes available, currency withdrawal limits will be relaxed, but those who deposit more than Rs. 250,000 (about $3676) in old notes face promised scrutiny by tax authorities.

Currency transactions play a huge role in the Indian economy. To list some pertinent facts about the importance of currency in India:

Over 90% of all transactions in India are (or were) conducted in currency.

47% of the population (almost 600 million people) is unbanked, unable to substitute into check-writing or debit or credit card use.

The Reserve Bank of India puts currency held by the Indian public at Rs. 17 trillion, or 62% of M1 (the sum of currency and checkable deposits).

The two invalidated note denominations make up more than 80% of currency in circulation.

Half of India’s money stock (80% of 62%) has thus been at least temporarily immobilized. The immobilization imposes special hardship on the unbanked population. About 30% of the population lack even the basic ID required to change old for new currency notes. Those who sell old notes for new in the informal market suffer a loss of around 20% (the exchange rate reported in recent days).

Here we consider three different aspects of India’s currency cancellation policy: (1) the effects of transition away from old notes, (2) the fiscal impact of transition into new notes, and (3) the impact of the non-uniform injection of the new notes into the economy.

1. Effects of transition away from old notes

Modi’s surprise announcement imposes a one-time wealth loss on currency holders who are unable or unwilling to convert their entire holdings of old notes. This is actually intentional, because the idea is to eliminate untaxed or illegally gotten wealth held in currency.

The currency policy is effectively a massive one-shot transfer of wealth from the private to the public sector.

Modi seems to have underappreciated, however, that in so doing his policy creates a serious shortage of currency. This shortage blocks ordinary currency transactions, blocking honest ordinary people from making a living, thus reducing national income. The biggest impact is on the poor, who have few substitutes for cash transactions. In the last two weeks, some daily wage laborers have not been paid due to the currency shortage, and are down to only one meal a day because of the drop in earnings. Farmers and vendors unable to sell fresh produce have lost their entire stock of perishables. Other small businesses are unable to operate without access to sufficient new currency notes. And since November 9, close to 50 deaths have been attributed to the currency shortage. A policy ostensibly intended to inflict losses on tax evaders and criminals is imposing, at least in the transition, much greater losses on honest users of currency.

2. Fiscal impact of transition into new notes.     READ MORE HERE