Flow of old currency notes

Signs of a growing economy can be seen in the increasing M3 money supply. Accompanying graph shows the total deposits with the banking system in India. The number is about 6 times the currency in circulation, and growing rapidly quarter after quarter. The data is not perfect, as few banks and remote locations continue to operate on paper based ledgers and report selectively. One needs to provide for a possible deviation from the reported figures, but the trends are hard to miss. Latest release from RBI says that a net amount of about 4.1 trillion was deposited since the demonetization started, taking the total deposits from 100 trillion to 104 (brown thick line). This is very good news for the implementation. Going forward, there are two scenarios - 1) blue dotted line all the old bills are deposited, or 2) brown dotted line indicating the pace of deposits slows down in coming weeks and just about half of outstanding currency notes are deposited.

What is likely to happen to all the old currency notes? Let's look at the mechanics of demonetization from this perspective, and then see if it can do us any good. Broadly speaking, there are only four possibilities with the 22 billion or so currency notes that seized to be legal tender earlier this month. But before that, let us grasp who uses currency.

For convenience, I divide the Indian citizens in to five groups (the recommended number for market segmentation) - Jan Dhan Mazdoor, Salaried Middle Class, Businessman with reported income, Black Business (a.k.a. politics) including persons whose wealth originates from corruption, and lastly Farmers with one account in family. These groups are distinct when it comes to their financial reporting, otherwise they're just like you and me; someone in the family; a friend in college; a neighbour; etc. The financial differences are that Jan Dhan Mazdoor has nothing to report, Salaried Middle Class reports everything until he/she gets in to real estate, Businessman reports income when absolutely necessary, Black Business doesn't report and Farmer doesn't pay taxes even if he reports.

1) Deposit in Bank

Starting 10th November 2016, people and organizations, rich and poor, honest and evading, queued up to deposit old currency. Queues were even longer for exchanging the currency, for whatever reasons. Many still haven't done either of this yet! But most individuals will deposit the old currency by year-end. The press release for amount of deposit has just come from RBI, and the numbers are very encouraging!


If a person holding say 1 Crore in old currency decides to declare the wealth and deposit, then he will have to show a source of income. Most likely, it would be a previously unreported source of income through misrepresentation of facts. I'm not a tax expert, but if the source is not agriculture or gift, then there is a 200% penalty on tax. For average effective tax rate of about 23%, the depositor will end up paying 69 lakhs to government and keep 31 lakhs for future use. Not many will like their hard earned money to shrink so much!

There are reports of Jan Dhan Mazdoors and Salaried Middle Class getting offers to deposit cash on behalf of someone in business end of it. Nobody knows how many people fall for such offers. But barring that lot, its going to be honest people or neo-honests who will deposit. Real black cash is unlikely to be deposited. Nonetheless, one would see a lot of deposits - at least about 2 lakh crores (2 trillions) - that's 20 crore households depositing 10,000 each. A lot of it would be working capital used by businesses. Maybe 1% of this would be previously unreported income. So, government doesn't gain much in tax collection. The gains would be that a large fraction of this 2 lakh crores will now be used without withdrawing - through money transfers, debit cards, cheques and mobile platforms. Thus, with every deposited note, the likelihood of a white transaction happening goes up - not just during the period of currency shortages, but beyond. I like the prevailing currency shortage, as it is forcing people and businesses to use a more efficient way to transact!

2) Burn or Destroy

The real fun that the masses were waiting to see was rich people running from pillar to post with suitcases full of money. Germans have a term for this pleasure in someone else's plight - schadenfreude. Following video is doing rounds on WhatsApp proves that we are experiencing schadenfreude.

Its a natural and rational response for someone stuck with a lot of unreported money to find ways to come out of the situation. Reporting wealth and taking 69% hit may sound good on paper, but, for someone whose source of income exposes further black wealth (say real estate), it would be suicidal. Such a person may prefer to destroy currency notes rather than depositing or exchanging - officially or unofficially.

I expect anyone with benaami properties to take this route. My guesstimate is that nearly one-fourth of total currency in circulation will be destroyed. That's a whopping 3 lakh crores !

Isn't this a loss for the economy? If one treats entire economy of a country as a firm, we destroyed value of the economy by destroying an asset which could have generated future returns. Its like an industrial accident destroying a plant, and there is no insurance! One could have bought crude oil for next few months with this money. 

Well, yes and no! Continuing the analogy of firm, currency in circulation is like outstanding shares of a company. The more you issue, the less is its value - both domestically due to inflation, and internationally due to exchange rates. So, yes we may lose productive assets (currency) that could have given us future returns; but reduced money supply can also appreciate rupee. Alternately, RBI can increase the supply of M2 / M3 money - pushing down interest rates (already fallen by 0.36% ). Even in the absence of such benefits, I would still not mind people burning up cash (literally), looking at the moral side alone.

3) Convert to 100s or 2000s

A sane businessman with a lot of cash would neither like to burn it nor like to take 70% hit on it. The businessman would rather choose to convert it in to something else. 100s or 2000s; or something that's tradeable like gold. Surprisingly, I didn't find any rush around the jewelry shops situated along my daily commute - imagine the kind of expectations my wife could have!

In my view, its this hoarding of 100s is the real reason for any shortage. Evidence of this can be seen in an employee driven retail store, where cash counter is difficult to hide; versus a restaurant that is managed by family. Restaurants in my locality are offering 25% discount on the bill, if payment is made in 100s, whereas the retail store we frequent is flush with 100s till a supervisor comes to collect.

If whatever I said here is true, then it is disturbing, and completely under the radar of the government. The people with unaccounted 500s and 1000s will continue to hold currency notes, with 2000s and 100s. At the moment, informal sources tell me that 100s are available at 50% premium.

Even if the original owner of unaccounted currency doesn't deposit with a bank, someone else does. In the restaurant example, perhaps the owner will deposit old notes by showing it as part income and part working capital. The restaurant is likely to switch more and more upstream transactions to white, provided that's his main business.

4) Continue to transact

Private circulation of old notes may continue to take place beyond 30th December. Legality of all this is not clear yet. People do collect and preserve old currency notes for antique value. These get traded at a premium too.

Albeit, this will be a negligible fraction of total circulation.



So bottom line is that a majority of currency notes will get deposited, like they already have been. Some will get exchanged for goods illegally or other currency notes. Much of these would get deposited eventually, otherwise it has to be burnt. The third biggest portion would be the destroyed notes. The destroyed notes is the extent to which we manage to curb black money stock in currency. The blue pie describing the deposited currency is more likely to be spent on white economy, and as mentioned in earlier post could form another measure for success of the scheme. Going forward, it will be interesting to watch these indicators - some of them measured, some are not really measured by anyone!

The hope is that the Jan Dhan Mazdoor and Salaried Middle Class switch to whiter transactions. Regular businesses reduce their exposure to black transactions. As I write, many are forced to adopt electronic currency and reduce the exposure. The bubble of black business shrinks for want of willing partners.