In this post, I attempt to understand the possible outcomes of the move. Its based on available public information, news and rumors as on date.
We know that there is substantially less currency in the system as compared to 8th November. Roughly, we have one fourth of total currency by value. Some transactions have moved to electronic platforms, which show a two-fold increase in transaction value. This increase does not compensate for the loss in currency transactions. Accompanying graphic shows that the cash in the economy has shrunk significantly, to a level comparable to the most cashless economies. At this level, if entire stock of 100 rupee bills is in circulation, then most of the low value transactions should continue to happen. Yet, there are reports of vegetable vendors and other small establishments; and common people facing difficulties in transacting. Reasons for shortage are many - panic hoarding of currency by people to take care of emergencies, mismanagement on part of administration, and conversion of black 500 / 1000 in to white 100s. Bottom line is that the volume of transactions are hit. This is the temporary hardship for 50 days that PM has talked about. In addition, many man-hours are lost in bank / ATM queues. This could also impact the productivity and spending. On the ground, a look at old market shops would tell you that volume of transactions are hit. But, we'll tide over this soon!
One short term solution is that credit is given by buyer or seller; and settlements made once currency flow eases. In some places old notes are getting used, in others chits and stamped papers. All are examples of trust based credit, backed by a paper.
What happens in the long run? At this time, it appears that the RBI will reduce the supply of currency notes and coins (M1 money), otherwise the entire exercise is meaningless. It would be like removing the cobwebs during diwali and leaving behind spiders. The spiders will form cobwebs again! My hunch is that we'll cross the grey circle by a big margin, and be somewhere at 50% of orange circle. If that happens, and say we have half of what our economy had on 8th November, we will be running the economy with 8 lakh crores cash give or take. For this amount of cash to reach the remotest parts of the country; 50 days are just enough. So I don't take reports such as this and this seriously.
The bigger question is would 8 lakh crores be sufficient? Will there be shortages of currency notes, the way we face shortages of coins? Will people use gold coins just like retailers used chocolates?? Other countries are running with far fewer currency notes (per unit GDP). Will we be able to do it without much inconvenience?
The answer lies in an elementary concept of economics known as velocity of money. In simple words, more transactions should take place for every currency note. A note bearing a certain serial number should change more hands on a given day, than it used to. There are markets in our country, in which dozens of transactions take place on a particular currency note in a given day. Rest of the economy should adopt that efficiency. Yet, nothing increases the velocity of money as good as switching to electronic payments.
A report by World Economic Forum shows that only 20% of transactions are electronic (by value) in South Asia, whereas OECD countries have achieved over 60% electronic money. In my experience, most registered companies in organized sector use cheques or electronic payments for their reported transactions. Its the micro enterprises and informal sector that are slow to adopt financial institutions, or electronic payments. With options such as paytm, MobiKwik, PayUmoney, M-pesa, and Unified Payments Interface of NPCI; there going to be an explosion in electronic payments at small and micro establishments. The shortage of currency notes may provide a much needed tipping point. Even before the announcement of currency replacement, industry experts have pegged the growth rate in plastic money and mobile payments at high double digits (30-70%). If these are to be believed, then before next general elections in 2019, we may be seen using as few currency notes as OECD countries ! Thus, a higher penetration of electronic payments is expected to take place in both urban and rural marketplaces.
However, ease of transactions is not the real reason why Indian economy built up so much M1 money (currency). The biggest reason lies beyond the operational aspects. Any amount of cash is insufficient in India for a deeper reason. We the citizens are habituated for freebies, for evading taxes and for avoiding other forms of user charges.
For instance, the biggest concerns for anyone I talk to is about the civic amenities provided, and yet the tax collection rates in best of our civic bodies barely crosses 40%. This implies that 60% of properties are existing without fulfilling their share of promise (tax payments). I'm taking the civic body example because for property tax, it is possible to calculate the collection rate in the first place. The tax is usually on a stock quantity - number of households in a city; which is a verifiable tangible asset that can be observed at any point in time. Now let us extend the argument to areas where a collection rate is not possible to be calculated, because we don't have enough data. In my previous post, I mentioned that we don't have reliable estimate for size of black economy. The economy cannot be verified at any point like an immovable property. To assess a reliable tax base on transactions (sales tax, VAT, excise, etc.) or direct taxes; one needs to know the value of total flow. This requires 24/7 vigilance at all places by the government. This is impossible to achieve. So, we as citizens try to hide the transactions and income. We undertake anonymous transactions with cash. This is where we have the roots of black money - buyer wanting to hide identity, seller wanting to hide identity or both wanting to hide identity. A shrewd businessman can sell goods and receipts separately. There is a market for such things. Isn't it possible to buy medicines without receipt; and to buy a receipt without the medicines?
A possible side effect of reduced M1 money is that some buyers and some sellers will not be able to lay their hands on currency notes. Such people are in minority at the moment, even after demonetization. Only when there are a large number of such people would one see a palpable impact of the demonetization move. Whether such a shift to white transactions happens will depend on push and pull factors identified here.
We know that there is substantially less currency in the system as compared to 8th November. Roughly, we have one fourth of total currency by value. Some transactions have moved to electronic platforms, which show a two-fold increase in transaction value. This increase does not compensate for the loss in currency transactions. Accompanying graphic shows that the cash in the economy has shrunk significantly, to a level comparable to the most cashless economies. At this level, if entire stock of 100 rupee bills is in circulation, then most of the low value transactions should continue to happen. Yet, there are reports of vegetable vendors and other small establishments; and common people facing difficulties in transacting. Reasons for shortage are many - panic hoarding of currency by people to take care of emergencies, mismanagement on part of administration, and conversion of black 500 / 1000 in to white 100s. Bottom line is that the volume of transactions are hit. This is the temporary hardship for 50 days that PM has talked about. In addition, many man-hours are lost in bank / ATM queues. This could also impact the productivity and spending. On the ground, a look at old market shops would tell you that volume of transactions are hit. But, we'll tide over this soon!One short term solution is that credit is given by buyer or seller; and settlements made once currency flow eases. In some places old notes are getting used, in others chits and stamped papers. All are examples of trust based credit, backed by a paper.
What happens in the long run? At this time, it appears that the RBI will reduce the supply of currency notes and coins (M1 money), otherwise the entire exercise is meaningless. It would be like removing the cobwebs during diwali and leaving behind spiders. The spiders will form cobwebs again! My hunch is that we'll cross the grey circle by a big margin, and be somewhere at 50% of orange circle. If that happens, and say we have half of what our economy had on 8th November, we will be running the economy with 8 lakh crores cash give or take. For this amount of cash to reach the remotest parts of the country; 50 days are just enough. So I don't take reports such as this and this seriously.
The bigger question is would 8 lakh crores be sufficient? Will there be shortages of currency notes, the way we face shortages of coins? Will people use gold coins just like retailers used chocolates?? Other countries are running with far fewer currency notes (per unit GDP). Will we be able to do it without much inconvenience?
The answer lies in an elementary concept of economics known as velocity of money. In simple words, more transactions should take place for every currency note. A note bearing a certain serial number should change more hands on a given day, than it used to. There are markets in our country, in which dozens of transactions take place on a particular currency note in a given day. Rest of the economy should adopt that efficiency. Yet, nothing increases the velocity of money as good as switching to electronic payments.
| Images of micro entrepreneurs using electronic payment are doing rounds on WhatsApp |
However, ease of transactions is not the real reason why Indian economy built up so much M1 money (currency). The biggest reason lies beyond the operational aspects. Any amount of cash is insufficient in India for a deeper reason. We the citizens are habituated for freebies, for evading taxes and for avoiding other forms of user charges.
For instance, the biggest concerns for anyone I talk to is about the civic amenities provided, and yet the tax collection rates in best of our civic bodies barely crosses 40%. This implies that 60% of properties are existing without fulfilling their share of promise (tax payments). I'm taking the civic body example because for property tax, it is possible to calculate the collection rate in the first place. The tax is usually on a stock quantity - number of households in a city; which is a verifiable tangible asset that can be observed at any point in time. Now let us extend the argument to areas where a collection rate is not possible to be calculated, because we don't have enough data. In my previous post, I mentioned that we don't have reliable estimate for size of black economy. The economy cannot be verified at any point like an immovable property. To assess a reliable tax base on transactions (sales tax, VAT, excise, etc.) or direct taxes; one needs to know the value of total flow. This requires 24/7 vigilance at all places by the government. This is impossible to achieve. So, we as citizens try to hide the transactions and income. We undertake anonymous transactions with cash. This is where we have the roots of black money - buyer wanting to hide identity, seller wanting to hide identity or both wanting to hide identity. A shrewd businessman can sell goods and receipts separately. There is a market for such things. Isn't it possible to buy medicines without receipt; and to buy a receipt without the medicines?
A possible side effect of reduced M1 money is that some buyers and some sellers will not be able to lay their hands on currency notes. Such people are in minority at the moment, even after demonetization. Only when there are a large number of such people would one see a palpable impact of the demonetization move. Whether such a shift to white transactions happens will depend on push and pull factors identified here.
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