While the world was waiting for the US election results, PM Modi in an unprecedented move on 8 November 2016 demonetised INR 500 and INR 1,000 notes, effective midnight. In the short-term, everyone will be affected and inconvenienced, but there are larger economic gains ahead.

Seizing Terrorist Funding

The move is a step towards curbing the financing of terrorism through the proceeds of Fake Indian Currency Notes (FICN) and use of such funds for subversive activities such as espionage and movement of contraband into India. FICN in circulation in these denominations is comparatively larger as compared to those in other denominations. It may be noted that the total number of bank notes in circulation rose by 40 per cent between 2011 and 2016; the increase in the number of notes of INR 500 denomination was 76 per cent, and for INR 1, 000 denominations, it was was 109 per cent during this period.

In its June 2013 report, the Financial Action Task Force stated that high-quality counterfeit Indian notes were “printed in Pakistan and then smuggled into India through transit points at Dhaka, Sri Lanka, United Arab Emirates and Bangkok.” According an Intelligence Bureau report, every year almost INR 100 crore is being funnelled from Pakistan to Kashmir through Hawala channels. Through this move, Prime Minister Modi has sought to cut the cord of funding of the terrorists flourishing in the state of Jammu and Kashmir.

Eliminating the Black Money Market

This move is a step towards eliminating black money, whose parallel economy casts a long shadow on the real economy. The use of high denomination notes for storage of unaccounted wealth has been evident from cash recoveries made by law enforcement agencies from time to time.

The Finance Ministry’s 2012 White Paper on Black Money clearly acknowledges the primary importance of cash in relation to both the generation and use of black money. Black money is directly related to a variety of cash transactions in the parallel economy. It represents not less than one fifth of the aggregate economic transactions. The move will affect over 86 per cent of cash transactions and encourage electronic transactions. With almost 60 per cent of the economy estimated to be a cash economy, the decision is likely to be quite disruptive in the short-term, but the transitional discomfort and resistance will wane once people start looking at the bigger benefits for the economy. In 2007, the World Bank estimated the size of India’s shadow economy at 23.2 per cent of GDP. Assuming this ratio still holds, that is about US$ 479 billion unaccounted for. Much of that money is expected to be mainstreamed because of the demonetisation.

Macro-Economic Benefits

A CRISIL report states the significant structural benefits of the move over the long-term. In the short-term, GDP growth may be negatively impacted as the cash-based economy feels a crunch, and consumption and investment moderates, but this will spell significant structural benefits over the long-term as the direct tax collections are expected to rise. However, millions of small enterprises in the unorganised sector that use cash to transact will be inconvenienced for a while.

Over the long-term, however, it could change the face of the Indian economy, and improve the government’s fiscal position and tax compliance. Income tax revenue collections are expected to see a direct positive impact as funds earlier unaccounted for will enter the banking system and eventually get taxed. With the Pradhan Mantri Jan-Dhan Yojana in India, citizen access to bank accounts is nearly complete. This move would have been impossible if low-income households were unbanked.

Inflation will see some downward pressure in the short-term because cash transactions will reduce. In the long run though, as government spending rises, demand will revive. Therefore, the impact on inflation will be neutral in the medium-to-long term.

Election Woes for Political Parties

Black money and huge cash distributions take place during elections and this move will certainly cause the political parties some discomfort. In India, the INR 500 and INR 1,000 notes also constitute a huge percentage of the money spent by governments, political parties and candidates during general elections. A Centre for Media Studies report in the year 2014 showed that nearly INR 30,000 crore was spent during the 2014 general election, while official spending only accounted for INR 7,000-INR 8,000 crore.

What created the maximum havoc in the country was the strategic move by the government to make the announcement post banking/working hours. It gave no scope to those who have stashed away unaccounted cash in their attempt to play hide and seek with the government and regulators.

Lastly, after all the applause, one must not forget that the utility of the move depends on how effectively the government is able to monitor the exchange of currency, for which it has unveiled a measure wherein cash deposits above INR 2.5 lakhs will be taxed, besides the 200 per cent penalty in case of an income tax mismatch. It would serve no purpose if hoarders devise smarter ways to circumvent these measures.