Why did India suddenly decide to ‘withdraw’ the 500 and 1000 rupee notes?

Hello readers, welcome bank to rsira-economics.com where as usual I will be giving my take on the top trending economics news stories. Last week I discussed the impacts of the outcome of the US presidential election and how Mr Trump… perhaps I’ll stop there, we don’t need to discuss that for another 4 years. This week, I will be discussing why India suddenly decided, overnight to remove its largest denominations of the rupee: the 500 and 1000 notes and replaced these with a new crisp, purple note worth 2000 rupees. It caused lots of economic turmoil and had a number of significant impacts on the everyday person in India as well as affecting many firms and businesses, but at the same time it has proposed a number of key benefits for the country. In today’s post I will try to outline the general reasons for why India has done this, what this will mean (costs and benefits), and how exactly it will help. I aim keep this short and to the point whilst making it detailed, but still accessible to the non-economists out there, who are reading this. If you have a few minutes to spare, give my view on the current situation a quick read and hopefully it will all become much clearer for you. As always please post any comments below and I will try to respond to them. Alternatively you can email them to me at rajveersira@gmail.com

With corruption becoming more and more of an issue all around the world and leading to an inevitably poorer economy, it is putting pressure on governments to tackle such issues and clamp down on this. India, a country with over a billion people is ranked at 65 on the corruption index out of 150 countries and although this is not too bad, the problem of corruption and illegal cash holdings has become a widespread, ubiquitous issue throughout the country. India and its government believe that by removing the two largest notes, it means that people will be forced to change their old notes to the newer notes and in doing so it will remove high proportions of ‘black money’ from the system, which is money that should have been taxed and had not, or money that has been acquired in an unlawful manner e.g. drugs or stolen money. The finance Secretary of India, Shaktikant Das said that banks will be “closely monitoring the exchange of old notes for new notes” in order to catch those out who have been hiding large stashes of cash. Most transactions made in India are through cash as there is a large proportion of people without cards, mainly those living in slums or in absolute poverty (those who earn less than the equivalent of $2 a day). This is a major inconvenience to the local people as it means that around 1 billion people will have to make a trip to the bank or local post office to get their notes changed. This may seem like a simple task in your head when you are reading this, as all it means is that they just have to pop down to their local branch and exchange their notes. Simple. Surely? Well the pictures below kind of sum it all up. In a country where there are so many people, services and infrastructure are simply overwhelmed and cannot cope with the number of people depending on them on a day-to-day basis. This extra influx of people will be chaotic and with only about 50 days to change your notes, it seems like a recipe for disaster. If people aren’t able to change their notes in this time then their notes will simply become meaningless, worthless, pieces of paper.

screen-shot-2016-11-22-at-22-06-29screen-shot-2016-11-22-at-22-05-03

 

 

 

 

 

In addition to this, no one saw it coming, not even the news organisations and as a result it caught everyone off-guard; however, this was always the plan. The secrecy of the operation and limited time allocated to change the notes was exactly what Mr Modi was hoping to achieve, as it will hopefully clamp down on corruption. One might argue that this would have been a much smoother transition if India had given the country warning and longer to change these notes, although if that were the case, it may have not helped at all and could have even led to money leaving the country into off shore illegal accounts or other illegal practices such as money laundering.

Furthermore the notes were made no longer a legal tender on the midnight of the announcement, creating a panic-stricken population and radiating shock waves across the country. The worst impact was on the poorest in society as they only deal with cash and their businesses depend on cash flow, thus they were severely affected. What makes matters worse is that most of the people who voted for Modi were among some of the poorest citizens and now they appear to be in the worst position. Although it’s not just the poor who have been affected, large corporations and businesses have experienced huge amounts of disruption.

On the day of the announcement, it prompted people across the country to rush to ATMs that offer 100 rupee notes in an attempt not to be left without cash over the next few days. This whole upset to the system, has certainly created uncertainty in the economy, and already with so much uncertainty looming over the globe at this moment in time it is questionable as to whether this was the right time for the Indian government to act. However this has always been Mr Modi’s goal and when his party the Bharatiya Janata Party came into power in 2014, they promised to bring billions of dollars of black market money into the country’s financial system.

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The official economic term for what has happened is “demonetised”. So we can say that the 500 and 1000 rupees ($7.50 and $15) notes were demonetised, which in simple terms means they have been taken out of the system.

There are no precise figures available but experts say the government’s move could be “a very powerful measure” to curb “black money”. On the flipside, whether or not doing all this will actually benefit the economy is still unclear as analysts have suggested that people may hire lots of other people to deposit their notes into their own accounts and then send it back for a fee, which is ironic as a scheme which aims to clamp down on corruption is in fact contributing to more corruption.

Only time will tell whether this has been the right decision by the government or not.

The latest developments so far on this story (from NDTV):

  1. The amount in exchange of old notes with new ones includes: 5.12 trillion rupees ($75.1 billion) in bank deposits and 33,000 crore rupees ($ 4.85 billion).
  2. The central bank has made a series of announcements, allowing banks to give borrowers an additional 60 days for repayment of housing, car, farm and other loans under one crore.
  3. The RBI has eased cash withdrawal rules for businesses, saying overdraft and cash credit account holders can now withdraw up to Rs. 50,000 in a week now.
  4. To help farmers in the middle of the Rabi sowing season, the government said on Monday it will allow them to purchase seed with the banned 500 rupee notes.
  5. The ban on high value notes has largely been praised by financial experts and analysts, but many have questioned its implementation and the government’s preparedness, with people having had to queue up for hours at banks to get rationed new notes amid a cash crunch.
  6. Prime Minister Narendra Modi has said there are teething problems in the implementation of a decision with long-term benefits for the Indian economy. The inconvenience to people will not last more than 50 days, he has said.

 

Sources used: BBC business news, The Economist and The Guardian, NDTV

 

 

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