Last week the Prime Minister of India made a surprise announcement. That within 24 hours, the country’s largest bills would no longer be accepted as legal currency. The financial move was initiated, to deal with the rampant corruption that permeates throughout the nation.
The government is removing the 500 and 1000 rupee notes, that is the equivalent of $7.50 and $15 dollars USD (United States Dollar) respectively. This will remove near 86% of the domestic currency that is now circulating in India, with a population of 1.29 billion.
Citizens will have until the end of year, to exchange the banned notes for lower denominations or new bills that are being created at local banks. Although they can no longer be used for most commercial transactions.
India is not the first country to eliminate larger bills to fight organized crime and disrupt the illegal flow of money. It is known as Black Money inside the country.
The United States stopped printing larger bills in 1945 and discontinued their use in 1969.
The $5000 and $10,000 bills had already for the most part, been taken out of circulation before then. After the 1960’s, the $500 and $1000 notes were withdrawn as well.
The $100,000 bills were only ever used for internal transactions among banks.
It should be noted that there is a growing movement inside the United States by businesses to no longer accept $100 bills, because of the high rate of counterfeit activity.
The note is also especially popular in the illegal drug trade,with terrorists and other illegal laundering groups, due to the acceptance of American dollars almost anywhere in the world.
The demand for dollars in many countries in the emerging world where there has been massive inflation or repeated devaluations, has continued over the decades. This has helped maintain the American dollar as the leading reserve currency in the world, despite the recent reckless fiscal behavior of the United State government.
Earlier this year, the European Central Bank (ECB) had decided to phase out the 500 note, worth about $575 USD by the end of 2018. This would leave the highest denomination in the Euro-zone at 200 Euros.
Switzerland has a 1,000 franc note worth about $1,050 USD, but its supply is quite limited.
South Korea will go even further. The government plans to go completely cashless by 2020.
Although the financial plan is creating a dramatic upheaval in Indian society, Prime Minister Narendra Modi felt his latest move had become necessary, to fulfill his commitment to fight crime. When he was elected in 2014, he pledged to fight against unaccounted for cash.
The edict has been tumultuous in India, because it is estimated a full 78% of all transactions inside the country involve cash. In contrast, the United States has a far lower rate of less than 25%.
The reform of the currency will serve a number of purposes, which includes helping the government clean up a corrupt system that relies on cash to function. It makes bribery and the avoidance of taxes through the underground economy, far more difficult.
It also will deal a strike against terrorist groups operating inside India. This will be achieved by making the movement of cash more problematic, especially since the present bills will become worthless at the end of the year.
In addition, it is helping the government in its efforts to combat the widespread problem of counterfeit currency. There is increasing evidence, that efforts to duplicate the present bills in circulation are becoming more prevalent.
It matters enormously to the Indian government. It is estimated that India lost near $344 billion USD in illegitimate currency outflows from 2000 to 2010 alone.
The Modi government attempted other financial measures, before this latest one. Under an earlier tax amnesty plan this year, the equivalent of nearly $10 billion USD in income was brought into tax compliance.
However, the effort to have citizens declare more income that is being earned abroad, or report a greater share of hidden assets had largely failed.
The prohibition on large bills, will hasten the country’s transition away from cash. It will force individuals with large sums in actual currency, to either come clean or risk losing their wealth.
Cash is so prevalent in India however, that the government was compelled to allow a 72 hour extension when paying for airline tickets and hospital charges.
As the prohibition works it way through the financial system, it will create major instability in various sectors of the economy. It could also hamper the present rate of economic growth of 7.56%, one of the best in the emerging nations.
Small businesses who have customers that are not connected to their money electronically, will be among the first to fell the effects of the move towards a more cash free society. Most of these operate unofficially, below the legal and regulatory structure of government. There will be a precipitous drop in customer purchases.
There are many among the poor of India, that do not own or have access to bank accounts.
The real estate sector will be another casualty of the move away from cash. A large percentage of property transactions, are still done in unaccounted for cash.
Developers often hold large sums of unaccounted for cash. As these pools of cash have suddenly become under question, it will be difficult for some firms to pay staff and suppliers. A number of projects will simply remain unfinished.
Valuations in property holdings, will be expected to drop under these circumstances.
These developments will be particularly difficult for many Indian politicians, who have large amounts of cash and are consequently also heavily invested in real estate. The scheme of converting contraband money into legal currency, will now be far more difficult.
Precious metals and numerous luxury items can also expect to experience lower demand, once Black Money becomes harder to accumulate and manage.
The biggest problem for those who hold large amounts of unaccounted cash, is the limitation on currency exchanges that were put in place, for the first two weeks of the new financial regime. That is only being allowed to exchange 4,000 rupees ($60 USD) daily.
Individuals who arrive at banks and post offices to exchange far larger hoards of cash, run the risk of being investigated by tax authorities. If they cannot explain how they legally accumulated the money they wish to deposit, they are supposed to be reported by bank officials.
Despite the headway that the government will achieve in dealing with the underground economy and the illegal flow of money, corruption will be reduced, but far from eliminated.
Like everything else that is done in India, there are a complex system of exceptions and exemptions to the new currency rules. What it is creating is confusion and in some cases fear. There are incredibly long lines at ATM’s (automatic teller machines) banks and post offices. Many people are frustrated, as they run out of cash to buy necessities and pay bills.
It will force many smaller enterprises into the legal economy. It is estimated that as much as a fifth of Indian GDP (Gross Domestic Product), is part of the underground economy. That would equate to more than $450 billion USD.
Now little more than a week later, the Indian financial system is in chaos. The central bank is struggling to print replacement denominations for the banned notes. Worse yet, the new notes are the wrong size for existing ATM’s. The Prime Minister had asked for 50 days of citizen patience, but the transition may now take as long as four months.
As with other aspects in the modernization of the Indian economy and society, the recent currency reform will have mixed results. The unforeseen consequences and poor implementation of the drive to eliminate corruption, has been no exception.