Q: What is meant by demonetisation?
Demonetization is the act of stripping a currency unit of its status as legal tender.
Q: What is a ‘legal tender’ ?
‘Legal tender’ is the money that is recognised by the law of the land, as valid for payment or discharge of debt. For a piece of paper to function as a medium or exchange and store of value, it needs to enjoy unquestioning acceptance from the public. This can only be ensured by declaring such paper currency notes as ‘legal tender’ through a fiat, with the central bank or the government promising to ‘pay the bearer’ an equivalent sum if the currency note is presented to them.
Q: How Currency can be stripped of its status as Legal tender?
The paper money derives all its value from the Government’s recognition of it. So once its recognition is cancelled, it loses its value, ie it becomes demonetised.
Q: Who decides on demonetisation in India?
The RBI Act of 1934 gives the central bank the sole right to issue bank notes. The act also gives the Union government the limited power to demonetise certain currencies through a notification.
After the 500 and 1000 rupee notes were demonetised with effect from November 8, 2016, the Government of India notification on February 27, 2017, stated that the specified notes cease to be the liabilities of the Reserve Bank and cease to have the guarantee of the Central Government.
Q: How much currency was demonetised on November 8,2016?
86% of cash in circulation was demonetised; which were the two largest denomination notes of Rs.500 and Rs.1000.
Q: What were the aims?
The aim was four fold:
- Curb corruption
- Curb counterfeiting
- Curb the use of high denomination notes for terrorist activities
- Curb the accumulation of black money
Q: What is the relation of cash and corruption?
On average, the use of cash will decline with development of the economy. But India’s cash level is some what higher in its income group. As per study by Transparency International, an NGO, the higher the amount of cash in circulation, the higher is the amount of corruption. And usually cash of higher denominations are associated with corruption. The most conclusive evidence comes from the ‘soil rates’ ie the rate at which the notes are getting damaged, to identify for what purpose cash is used in an economy. The currency used for transactions should have high soil rate. Indian soil rate of higher denomination currencies are lower, indicating there are rather used for storing than transacting.
Q: What are ‘black’ and ‘white’ money?
Black money is that earned through tax evasion or corruption. White money is that having proper sources of income and is declared to the income tax department.
Q: How ‘black’ can be converted to ‘white’ money?
Most common way is Laundering, ie is passing it on to the formal system as if it is white money through various methods. Black money can be declared to authority by paying tax and penalty to make it ‘white’. There can be other ways also.
Q: Was demonetisation a standalone action?
No.The demonetisation followed a series of efforts to curb the illicit activities. They are constituting Special Investigating Team on black money, passing Benami transaction bill, making Information exchange agreements with other countries, making changes in tax treaties , putting an Income disclosure scheme etc
Q: What were the Previous demonetisation events?
There were in 1946 and 1978
Q: How India’s demonetisation was an unconventional one?
Normally the unconventional monetary policies used are to stimulate the economy, by pumping more money to the economy called ‘helicopter drops’. India’s demonetisation was opposite, i.e. to reduce the money supply, especially when the economy was in a stable growth trend.
Q: What are ‘helicopter drop’ and ‘helicopter hoover’?
Helicopter drop is an unconventional tool of monetary policy that involves printing large sums of money and distributing it to the public in order to stimulate the economy.It is used to jumpstart the economy during deflationary periods. Helicopter hoover is a ‘reverse helicopter drop’ aimed to suck up the money.
Q: Is India a Cash-dependent economy?
Yes. Cash account for about 78% of all consumer payments.
Q: How demonetisation affected different sectors?
- Financial Sector – bank deposits increased; interest rates declined. If the increase in deposits are durable, it can reduce the lending rates.
- Real estate – As the private sector wealth declined, the prices fell. The price decline can be sustained through further reforms in the sector.
- Cash intensive sectors – job losses, decline in farm income and social disruptions happened.
- Public Wealth – Income Tax collection has improved.Other payments like local body taxes, discom payments increased.
Q: What are the benefits of demonetisation?
- Tax on black money – Those with undisclosed income faced difficulties because, the money could not be exchanged at banks. They could declare their wealth but have to pay tax+penalty. Some were able to launder the black money, but at a higher costs. Also some portion of black money was not returned, which can be a saving for the RBI or government. Moreover income disclosure scheme Pradhan Mantri Garib Kalyan Yojana was opened to declare the undisclosed income.
- Better Tax Compliance – The strong political commitment on eliminating black money will incentivise better tax compliances. Demonetisation has shifted many transactions out of cash economy to the formal payments system.
- Tax on informal savings – As cash was converted to bank deposits with restrictions of withdrawal in place, the formal saving has improved, which can be used by banks for providing more loans and help in long run growth.
Q: What are the long term impacts of demonetisation?
The potential long term benefits are
- Digitalisation – Less cash economy will have more savings and transactions channelled through formal financial systems, thus improving the tax compliance. This will help to create a level playing field for all firms.
- Real estate – In past much of black money accumulated was used in real estate sector. If the tax evasions are reducing in future, the present trend of decline in real estate prices will be sustained. It can help in affordable housings for all and reduction in rents which in turn help the labour mobility.
Q: How will digitalisation affect the society?
It will affect the different sections in different ways. The poor who are largely outside the digital economy will suffer the most. The less affluent, who are becoming part of digital economy through Jan Dhan accounts and RuPay cards will able to cope up with the cashless situation. The affluent who were fully digitally integrated will be least affected.
Q: What were the steps taken by government to facilitate digitalisation?
- Launch of BHIM(Bharat Interface for Money) app for smart phone users.This was based on UPI(Unified Payments Interface), which created inter-operability of digital transactions.
- Launch of BHIM USSD 2.0 for feature phone users
- Launch of Aadhaar merchant Pay, which can be used by non-phone users also.
- Reduction in Merchant Discount Rate for the digital transactions
- Tariff reductions on POS(Point Of Sale) machines
Q: What are the short term impacts of demonetisation?
There are some short term negative impacts.
- In adequate supply of cash – there was a supply and demand mismatch in the post demonetisation period. This affected the informal sector more.
- Adverse impact on GDP/economic growth
Q: How does demonetisation impact the GDP?
The demonetisation created a demand shock(affected private wealth), supply shock(reduced cash input for economic activities like agriculture) and uncertainty shock(caused consumers to defer consumption and investors reconsider the plans). The impact of these on the economic activity can be analysed through the trends in agricultural sowing, indirect tax revenue, auto sales, real estate prices and real credit growth.
Agricultural sowing did not show a decline. Indirect taxes which is a gauge of production and sales showed decline. Sales of two wheeler declined, where as that of passenger car sales showed little impact. It can be concluded that real GDP and economic activity was affected adversely. The adverse impact will be transitional.
Moreover the recorded GDP growth figure does not capture the actual demonetisation effect because, most affected part is informal and cash-based economy, which is not captured or only indirectly captured in the GDP figures.
Q: Is demonetisation a redistribution of resources?
Yes. The demonetisation has shifted wealth from private sector to the government. Also Laundering of black money have redistributed some wealth.
Q: What is the desired ‘remonetisation’?
Full internal convertibility should be re-established i.e., the public should get the amount of currency they wants, there should be no withdrawal limits nor penalties on withdrawals.
Q: Is demonetisation a Success?
Initial studies shows it can be a success. The economy will rebound from the short term adverse effects. The markers of the long term success will be increase in digital payments, reduced cash to GDP ratio and increase in tax collection of both direct and indirect taxes.
Q: Is the job finished?
The demonetisation is not a standalone act to fight corruption and black money. The incentives and actions should be carried on for better compliance. Implementation of GST and other structural reforms are required to put the growth on desired trajectory. Remonetisation should be expedited. Actions should be taken to clear away uncertainty and dispel fears of an over zealous tax administration.
Q: What is the Way forward?
The government savings through unreturned notes should be used for capital expenditure. Digitalisation should be gradual, voluntary and inclusive. Digitalisation can be incentivised by government or RBI. Cyber security systems should be strengthened. There should be increased trust on formal economy and the digital transactions to keep public in the formal system. It should be accompanied by reduction in incentives for tax evasion.
The strategy can be
- GST with minimal exceptions
- Reduction in income tax rate and stamp duties
- Widening the income tax base
- Reducing corporate tax rate
- Improvements in tax administration