Demonetisation: Why Rs 4.5 lakh crore may vanish from the system

The government could carry out the demonetisation exercise over periodic intervals along with its surprise element, says Soumya Kanti Ghosh.

Image: The work by sand artist Sudarshan Pattanaik in Puri, Odisha, seems to say it all. Photograph: PTI Photo.

The recent government move on demonetisation is a welcome one, but the implications need to be understood properly. For one thing, black money/unaccounted cash and black economy are two different things, with the latter thriving on the former.

Conservative estimates put the size of the black economy in India at Rs 45,000 billion or Rs 45,00,000 crore. Various independent estimates indicate that around 20 per cent of such black money is in the form of cash possession (which arises from bribery, business malpractices etc) and the rest in land, real estate, jewellery etc.

It is this cash that the government is trying to unearth through this demonetisation move. However, the best thing is that the government is also trying to lay out a road map of disincentivising the creation of black economy through better tax administration and reforms among other things simultaneously.

There are several potential benefits of this demonetisation move.

We have constructed three plausible scenarios. In scenario 1 and 2 we assume that 50 per cent of the notes of higher denomination do not return to the system. It is also reasonable to expect that 60 per cent (in terms of value) of such Rs 500 notes and 40 per cent (in terms of value) of the Rs 1,000 notes would be exchanged at banks/post offices and the Reserve Bank of India (RBI) before March 31, 2017. Based on such estimates, roughly around Rs 4.5 lakh crore of money could disappear from the system.

This same situation had happened in the past also, when on January 16, 1978, by an ordinance currency notes of the denominations of Rs 1,000, Rs 5,000 and Rs 10,000 were withdrawn from circulation. Since the promulgation of the ordinance, until June 30, 1978, the high-denomination notes tendered for conversion to the RBI amounted to Rs 124.45 crore.

The amount of money coming back to the banking system was 75 per cent. The remaining 25 per cent did not return to the system possibly for the fear of getting tracked and thereby penalised.

Even if we assume that the same percentage of money is not coming back this time (remember, the RBI will only replace the notes that are recalled and not those that are not returned), this would mean an estimated Rs 2.5 lakh crore decline in currency in the system or 2.5 per cent of the GDP (gross domestic product). We call it Scenario 3.

The table above indicates the public holding of high-denomination notes worth Rs 9,926 billion (Rs 500 note value of Rs 5,498 billion and Rs 1,000 notes worth Rs 4,428 billion) as of March 2016.

Thus, in the three approaches there would be around Rs 248,200 to Rs 480,000 crore (Rs 2,482-4,800 billion) money that will not be converted and remain outside the banking system. To that extent, cash in the system may decline. On the lighter side, we hope too big an amount of such notes are not burnt adding to the Delhi smog!

How will this impact the RBI's balance sheet? First, the RBI is unlikely to know what is the percentage of notes unlikely to return, and makes a guesstimate.

Interestingly, in 1978, we observed that there was no significant decline in the currency in circulation. In such a case, there may be a cash payout against the extra notes printed by the RBI to the government. Alternatively, as the RBI will issue notes only against the old notes, there has to be a decline of an equivalent amount from the RBI asset side/cash payouts.

The RBI issues notes on the liability side and creates a corresponding entry on the asset side by, say, investing the foreign currency assets abroad in US treasuries in lieu of such currency holdings.

The investment income generated in turn is ploughed back to the government through dividend income, among others. Whichever way we look into it, we would expect the RBI to transfer this increase in windfall to the government over a period leading to significant fiscal headroom.

We believe this is the best thing to happen out of such demonetisation. In essence, if some of the sectors like real estate are severely impacted, expansionary fiscal policy supported by liquidity operations will be best suited given the experience of emerging economies.

Among the other impacts, we estimate a potential Rs 5 lakh crore could come back into banking channels because of this move. While a large part of this will be deposited in banks, the rest will be exchanged over the counter. Banks may see up to five per cent increase in CASA ratio. The impact as a result of this could be 0.5-0.6 per cent of the GDP.

We also suggest, based on our analysis, that the RBI and the government should keep the ratio of Rs 100 and Rs 500 notes in the same proportion in circulation, even after printing new Rs 2,000 and Rs 500 notes.

Any deviation from the existing proportion will increase the cost of ATM replenishment and incremental increase in ATM transactional costs. Additionally, when the Rs 1,000 notes are reintroduced, in value terms, the ratio between Rs 1,000 and Rs 2,000 notes must be in the ratio of 50:50, because of the same reasons cited above.

In the end, this move by the government is a pragmatic one, as it will ensure India’s journey from an informal economy to a more formal economy. But the government must continue its efforts towards an enabling atmosphere for a less black economy through measures from time to time.

We suggest that this demonetisation may be carried out over periodic intervals with the surprise element and the government makes its intention clear on that. In such an eventuality, people will be discouraged to hold cash as they have been doing since 1978 and prevent any further build-up of a parallel economy.

Soumya Kanti Ghosh is group chief economic advisor, State Bank of India.