The independent think tank and leading business information company Center for Monitoring Indian Economy (CMIE) estimates that the combined cost of demonetization to enterprise, households, banks, and government (including the Reserve Bank of India) is about INR 1.3 trillion or about USD 20 billion.
Economists often use the concept of opportunity cost to understand what has to be given up in order to get what one wants: India has given up USD 20 billion, which could have been put to other uses, to get in return an economy with an expectedly far less unaccounted for cash, or in other words, India is expecting to “purchase” with USD 20 billion a far less corrupt economy.
Some estimates of India’s gross domestic product (GDP) for the period October-December 2016 say that nearly 1% could be shaved-off GDP growth. Are India’s prime minister Narendra Modi’s efforts to significantly reduce corruption by first clamping down on the cash unaccounted for by the tax authorities, or “black money” as they call it in India, worth the cost to the economy due to the demonetization drive and the consequent short term hit to GDP and the financial markets especially when interest rates are expected to rise in the United States after the election of Trump triggering capital flight from India and depreciation of the rupee just as it did previously during the taper tantrum when the U.S. Fed gradually ended its policy of quantitative easing?
The shock of about 86% of cash being taken out of circulation to remove, as economics Nobel Laureate Amartya Sen has pointed out, only 6% of black money that is actually in cash could, on the surface, seem excessive, but to disagree with Sen, there is no other alternative to demonetization to end the hoarding of ill-gotten gains. The government, in contrast to Sen’s labeling of it as being despotic in its actions, has, in fact, twice allowed the holders of hoarded cash to come forward voluntarily to convert it into white money by depositing in banks and paying the taxes with the penalties due on it. The INR 500 and 1000 notes continue to be legal tender as long as they are deposited in banks or exchanged for the newly designed INR 500 and 2000 notes within a prescribed timeframe: the government is indeed honoring its currency as legal tender. It is not despotic to ask cash holders to exchange old design notes for new design notes within a timeline.
At issue really is whether demonetization can actually end black money and other ill-gotten assets in the future. This is why it appears that it is a mistake to introduce two new currency notes of large denominations – the INR 500 and 2000 notes. Despite the government’s sound intent to convert what is a cash-based society into a digital society, the introduction of these notes poses the danger of recidivism. Moreover, once the circulation of cash attains normalcy again, the momentum gained toward a digital economy during the period of demonetization could be lost as people may tend to revert back to transacting in cash. It would, therefore, be good to see INR 500 and 2000 denomination notes demonetized with INR 100 becoming the largest denomination. Further, given that only a small percentage of black money is in cash and the rest of it lies in foreign currencies typically in Swiss bank accounts or offshore, gold, financial assets such as stocks, and real estate, it is unclear at this time how the government can account for all of it though the government needs to chart a clear course for it to forever end the shadow economy.
India is a highly desirable market to the extent that foreigners are willing to transfer technology to India to get a share of the Indian market. It is large enough not to depend on the comings and goings of foreign investment to be continually concerned about the depreciation of the rupee because of temporary domestic events such as demonetization or foreign happenings such as the election of Donald Trump in the United States. “Make in India” for the Indian market is a worthy goal to pursue for both foreign investors and Indian investors to reduce the reliance of the Indian economy on exports (and hence a cheaper rupee) as much as export competitiveness is necessary. More importantly, India can reduce imports, except of natural resources such as oil and gas and other minerals India does not possess, if it makes in India, boosting the Indian manufacturing sector. There is no reason at this time for the Indian rupee to depreciate against the dollar but for fleeting market sentiment about the prospect of higher US interest rates. India continues to be an attractive country for foreign direct investment (FDI) and foreign institutional investment (FII).
Strengthening the domestic market thus makes the rupee optimally strong at all times, similar to the US dollar, charting a path for the full convertibility of the rupee in the near future and its use as one of the reserve currencies in international trade. And all of this does not require dependence on cash because investment in India by both domestic and foreign investors can happen digitally and the economy can be steadily pushed to attaining the goal of all digital transactions by giving incentives to market participants and instituting laws to digitize especially when the technology to do so for all transactions, small and large, is readily available.
Digitization of the currency is the way to go and if the opportunity cost to achieving it is a small, short term, and temporary hit to Indian GDP and the Indian rupee, so be it.