Demonetisation of Indian rupee: Implementation hiccup and longer-term objective

Cash is king in India, or at least it was until in one sweep Narendra Modi scrapped two high-value banknotes in India in an all-out war to flush out black money, fight tax evasion, eradicate counterfeit notes used in terror financing and accelerate digitisation of the financial economy. Now the two highest-denomination notes, which account for 86 per cent of the value of cash circulating in India, cannot be used for purchases (with very few exceptions) and have to be deposited or exchanged in banks by the end of the year. The idea is that forcing people with large piles of cash to bring the notes in will allow authorities to investigate the origins of these fortunes.
So to cut right to the chase, how effective will demonetisation be in cleaning up ill-gotten gains? By now, it is common knowledge that money received from illicit tax-evading activities is mostly parked in real estate, gold, stocks and, most of all, in foreign bank accounts. According to reports in print media, less than10 per cent of black money in India is kept in hard cash.
Considering that black money can be earned both legally and otherwise, demonetisation could generate two distinct outcomes. In all likelihood, it can bring home some part of black money that was earned specifically through legal means. But black money created through nefarious activities will most likely be destroyed as owners might fear prosecution. That said, if this type of wealth is owned by politically influential individuals who can get their way by twisting 'appropriate' arms, the outcome might be all too familiar and certainly not desirable.
On the surface, it might seem easy to denounce the efficacy of demonetisation as a means of pulling the plug on black money. But perhaps we should take a step back and recognise that this effort is not intended to be the final nail in the coffin against a parallel economy, which is estimated to be in the order of 20 to 40 per cent of official gross domestic product (GDP)! Nor was it meant to put a lid on future creation of black wealth. Rather, it is part of a longer-term objective of creating a cash-less economy characterised by digitisation and higher financial sector efficiency where the honest man feels good about working productively and paying taxes.
Herein lies its biggest potential: igniting a structural shift in savings towards financial products in an economy where around half the population do not have bank accounts. It's about time too. With digital wallets and debit cards rapidly diffusing into almost every nook and cranny all over the globe, India's unbanked population, which account for two-thirds of South Asia's total unbanked and one-fifth of the entire world's unbanked, stands out as a glaring exception!
That brings us to the manner of execution, which many have described as 'bad planning' and 'botched up'. While at least in vision and objective, the Indian prime minister adopted Harvard Professor Kenneth Rogoff's suggestion, Modi's initiative is different in terms of implementation. Rogoff, in his book The Curse of Cash argued for a gradual exercise (as opposed to a sudden reform) and complete elimination of large notes (instead of exchanging them).   
Consistent with Rogoff's argument that a big-bang approach is severely disruptive to the economy, detractors of Modi's demonetisation drive raise concerns over the collateral damage caused by an overnight shock. Surely the honest citizen, elderly and housewives who live hand to mouth do not deserve to suffer stuck in endless queues in front of banks or ATMs to exchange their notes?
To be fair, the government's rationale that the suddenness was designed to prevent existing hoarders from converting their ill-gotten gains has merit. The alternative, a gradual time-bound plan that tracked large transactions, would have had obvious loopholes. Tax-evaders would have split up their loot into smaller transactions which are harder to trace; or they could have divided their pile of cash among several accomplices to buy other assets.
Another lingering confusion is why has the government issued an even higher-value note (2000-rupee) to replace the existing ones, which will undoubtedly render basic transactions even more excruciating? One argument could be that a tax-evader may try to circumvent the process by whitening only part of his black wealth paying the enforced tax and a penalty, withdraw it from the bank and then return later on to deposit the rest (or part of the rest) of his old black money while claiming that he is depositing the same legalised money he withdrew earlier. Therein lies the utility of a note new to the financial system, which allows authorities to differentiate between wealth that has gone through the demonetisation-filter and that which has not.
Be that as it may, there is no denying that a move towards complete elimination of high-value notes would have borne more fruit in the long-run. Perhaps when the ball gets rolling and a larger share of the population switch to electronic transactions, authorities might remove this crisp purple-clad new note.  
Setting aside the implementation factor, where does this monetary shock leave an Indian economy characterised by one of the largest share of cash relative to GDP in the world? For starters, the common man, enduring extreme hardship from a shortage of liquidity, will almost certainly put off purchases that is not absolutely essential.
At the sectoral level, cash-intensive industries like real estate, construction, transportation, gold and jewelry will no doubt feel the pinch of lower consumption demand. Farmers are facing difficulties in selling freshly harvested crops. Micro, small and medium enterprises, which operate on cash, are seeing their businesses slow down drastically.
The upshot is an across-the-board deterioration in major macroeconomic aggregates like consumption, production, employment, GDP growth and tax revenue in the short-run. In fact, analysts of the Indian economy expect demonetisation to knock off about 0.5 to as much as 2.0 per cent of real GDP growth this fiscal year.
But when the dust finally settles, the economy should reap longer-term dividends insofar as people are incentivised to save in financial products rather than unproductive physical assets like real estate and gold.  
The matter doesn't end there. Even if only a part of black wealth is brought under taxable radar, revenue will soar to new heights allowing authorities to turbocharge the economy through higher investment in infrastructure, energy and education or by passing on the windfall through further cuts in oil prices.
Another benefit accruing to the economy comes from the monetary and financial sector. Monetary transmission will most likely improve. Considering a short-term deflationary impact of demonetisation, the Reserve Bank of India (RBI) will have more leeway to cut policy rates. While banks, flooded with cash deposited by citizens, will be in better shape to lower lending rates. Lower corporate borrowing costs, if neatly supported by energy and infrastructure reforms, could galvanise private investment in India and spearhead economic growth in the medium to long-term.
The multiplier effects are not hard to imagine. Improvements in public finance and infrastructure bottlenecks coupled with a structural shift in savings towards formal financial products will boost sovereign rating; by extension, decrease external borrowing cost and lift foreign investment.   
That demonetisation will inflict short-term pain at both micro and macro levels is certain. While the extent of long-term gain still remains conditional upon several factors, including (a) how much money accrues to government coffers, (b) how this money is spent, (c) whether much-needed tax reforms are put in place, and (d) the extent to which government commits to its longer-term vision of creating a modern society where cash plays minimal role.
But dismissing the initiative without considering longer-term objective for which it was launched is unwarranted. For now, the jury is out on how successful Modi's war on black money will turn out to be.
The writer is a macroeconomic Research Analyst for an organisation in Washington D.C. and Research Fellow for the Asian Center for Development in Dhaka.
Views expressed are his own.   
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