Demonetisation FAQs: The Process, The Reasoning And The Necessity

Last week, I explained demonetisation at length – its principles, what it does and what it doesn’t. Here, I delve into the the process, reasoning and necessity of demonetisation.

1. Was the demonetisation route planned with any rigour at all?

The scale of preparation is noticeable from the way in which it was carried out. For example, almost no one has noticed that the Narendra Modi government has not called it a demonetisation move in its press releases. It has termed it as cancelling of the legal tender of high denomination notes. This is important because, as A K Bhattacharya has pointed out in Business Standard, post-1978, no demonetisation is possible except through an amendment of Section 26 (2) of the Reserve Bank of India (RBI) Act. Former finance minister Yashwant Sinha had to issue an ordinance to bring back Rs 1,000 in circulation. The unambiguous wording of the press releases show there has been a considerable degree of thought given to the hows of the move.

The finance ministry and the RBI realised that both the introduction of a new currency note of Rs 2,000 and the withdrawal of Rs 500 and Rs 1,000 will need an amendment to the law if demonetisation was to be done. So, instead, they used the power conferred by the Act to withdraw a legal tender and replace it with another set.

The other part of the plan was the resetting orders given to the Security Printing and Minting Corporation of India Ltd. There were two aspects to these orders. The push for indigenisation of the paper used for printing the notes and the addition of printing lines as per the annual report of the finance ministry. It was, therefore, not an ad-hoc decision.

The demonetisation process has little academic or administrative history to fall back upon. After this one, there will be a lot of new volumes on the process, but so far there is hardly any research paper in economic theories available on the whys and hows of demonetisation.

So, even if the finance ministry or the Prime Minister’s Office were to ask economists and administrators outside the government on how to do it, it is very likely that the experts would not have come up with any better suggestions themselves.

Several states, including Andhra Pradesh and Maharashtra, have asked for allowing cooperative banks to function as money-dispensing agents. But the cooperative banks do not have as many branches as post offices; so it makes little sense to give these banks the mandate to dispense cash. Besides, given the intimate connection of these cooperative banks with their politician owners, this might just be a good way to ensure that demonetisation fails in its objectives.

Once it has been rolled out, it is only then that the government can modify instructions, based on experience, which it has done. It is impossible that all of the changes made will be equally successful, but it is also possible that no matter what is done, the last-mile challenge of making cash reach those at the bottom of the food chain will take time.

3. How much of the currency needs to come back into circulation for normal conditions to resume?

Let’s look at the Rs 500 note, which is the most challenging unit of currency in this episode. There were about 16 billion pieces of these notes in circulation prior to 8 November. Since all estimates put the extent of black money in the range of 25-30 per cent, we can subtract about four billion notes as the sum not needed to keep the economy on its feet. The amount of currency people use as storage is about another fifth of the 12 billion (I am making this assumption on the basis of the ratio between M1 and M3 in India) to get a figure of about nine-and-a-half-billion pieces. Again, using the recorded production rate of the currency printing presses, they can supply about seven billion pieces a month. Since the overwhelming majority of it would be the Rs 500 note at this juncture, one should expect normalcy to return even in the deep rural pockets before the end of December.

To the extent that the middle class moves into electronic transactions, these numbers will improve, and the ATMs, banks and post offices should be streamlined earlier.

4. Was demonetisation necessary?

The primary reason for demonetisation was the massive rise in currency in circulation over the past one year. There was no apparent reason for this increase. The finance ministry has pointed to this development in its comments following the 8 November announcement; the State Bank of India Research Unit has referred to it in its publications and former RBI Governor D Subbarao has pointed to it in his article on demonetisation or de-legalisation. While the real gross domestic product rose by 7.56 per cent and inflation rose at 6 per cent, the currency in circulation rose by 15 per cent. It is, as he points out, “significantly faster than the trend rate of 10.7 per cent over the previous three years”.

Remember, the RBI itself has not accelerated its production of notes in the printing presses. Nobody has been able to provide a cogent explanation for this rise. There was obviously something happening here. This spurt can lead to a massive rise of money in the economy in the second order through the banking system.

Finally, here’s a question to draw a connection. What is common between banking cash transaction tax, Aadhaar-based identification of beneficiaries of government expenditure programmes, the move to exclusively card-based payment at petrol pumps and dematerialisation of insurance papers?

The answer – They are all meant to introduce transparency in financial dealings. Which is why they have been opposed vehemently by some sections.

Protests against demonetisation fit with that line of thought, just as Mamata Banerjee has opposed direct credit of NREGA wages to the bank accounts of beneficiaries, bypassing the state administrative structure. Incidentally, there has hardly been a murmur against her demand for this rollback.

Also Read:

Explained: What Demonetisation Does, And What It Doesn’t