India’s Demonetization Policy: Will it Work ?

Imagine one fine evening your nation’s top leader suddenly appeared on television to make an address. In this speech, he stated that the money which currently accounts for over 80% by value and 20% by volume of the entire money supply are suddenly going to be invalid i.e. worthless.

They would cease to be legal tender and would remain just worthless pieces of paper! Also, he would impose a bunch of restrictions on the usage of bank accounts until the problem was fixed. Sound like quite an ordeal isn’t it. This is exactly what happened to 1.2 billion people in India on the evening of 8^th Nov 2016.

Prime Minister Modi suddenly demonetized currency notes of Rs 500 and Rs 1000 denominations plunging the economy into momentary chaos.

In this article, we will study the reasons why such a drastic step had to be undertaken and what are going to be the likely implications.

Clamor over Unaccounted Wealth

The Indian population was fed up with unaccounted money. A small portion of the working class population had to share the burden of the entire nation. The poor class is so poor that they cannot even afford food, so the question of taxes does not arise. On the other hand, the rich had hoarded their money in the cash-rich economy and never paid any taxes.

“Black Money” as it is colloquially called in India was a major election issue in 2014 when Prime Minister Modi vowed to bring it back.

The entire population had all but forgotten about the black money promise when the Indian government suddenly sprang into action. Prime Minister Modi made a declaration after business hours that Rs 500 and Rs 1000 notes would suddenly cease to be legal tender.

The Government’s Plan

The Indian government noticed that almost all ill-gotten wealth is stacked in the form of high denomination currency notes. The realized that the cause of the problem was that people were not disclosing their wealth. Hence, the made these notes illegal.

Now the holders of these illegal notes will have two options. One, they can go to the bank and deposit this cash. The Income Tax department will obviously keep an eye on abnormally large deposits. If they get caught, they risk losing all the money and some more and may even be liable for imprisonment. This makes option one a difficult choice.

On the other hand, they could also simply forget about the money and absorb all the losses. This would seriously damage their wealth. In either case, the country would get rid of the black money and hoarders of this illicit wealth will have no option but to bear the loss.

Supposed Political Motives

The political establishment in India has said that Narendra Modi had personal gains in mind while implementing this policy. The elections at the state level are due in many parts of India.

An illicit wealth of this denomination is often used to rig elections and elect corrupt people to power. With the demonetization of such notes, the elections will be seriously impacted. Prime Minister Modi has brushed off these allegations.

The Most Affected Sectors

Not all sectors of the economy are going to be equally hit by the demonetization. Some industries are particularly prone to illicit transactions. These sectors include real estate and bullion. Both these areas saw heavy short selling in the stock market in the day immediately after the crackdown on black money.

The price of gold is expected to rise higher as people will hoard their future black money in gold. However, the prices of real estate are expected to come down by 15% to 20%. For the overheated property market, this may actually be a boon.

The Deflationary Effect

In the beginning, the money supply of India will be severely curtailed. Approximately $85 billion in black money circulates in India. Not even one-fourth of the money may be legalized into the new currency. This may levy a substantial deflationary pressure on the economy. The prices of everything from real estate to food stuff will decrease making people richer in terms of purchasing power.

The Inflationary Effect

In the medium to long term, the demonetization is likely to have an inflationary effect on the economy. This is because banks can increase the money supply with the help of something called as a money multiplier.

Thus every rupee invested in a bank will lead to loans worth four or five rupees circulating in the market. As soon as the banks can start lending money to the people, the inflation will resume. This inflation is likely to bring the asset prices back to ground zero albeit with a little correction. Black money’s favorite hoarding asset classes like real estate will not be overpriced.

The End Result

In the end, the inflationary and deflationary effects are likely to set off each other and cause a balance.

However, critics argue that Modi has only targeted the stockpile of black money currently present. What about the generation of new black money. The government has not taken any measures to curb the new supply. Hence the problem of black money has not really been solved.