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Why Narendra Modi’s demonetisation move is unprecedented

All previous radical monetary experiments have followed hyperinflation or protracted currency instability. Not this one.

Written by Harish Damodaran |
Updated: November 21, 2016 2:20:28 pm
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Historically, ‘demonetisations’ or radical recalls/replacements/redenominations of currencies by governments have been in response to hyperinflations. We know of many such cases of outright withdrawal of notes from circulation being resorted to, when normal means to suck up excess liquidity in the system have failed. The underlying purpose has always been to control runaway inflation and the accompanying loss of faith in the domestic currency, both among investors and the larger public.

WATCH VIDEO: Here’s What The Leader Of Bank Officers’ Union Said Over Demonetisation

The best example here is of Germany under the Weimar Republic, which, on November 20, 1923, introduced a new currency — the rentenmark — and declared all old reichsmark notes to be no longer legal tender. This happened as domestic prices, already 14 times their 1913 levels in mid-1921 and 1,475 times towards end-1922, had skyrocketed to 1,422,900,000,000 times by November next year. As the currency lost value by the minute, people rushed to spend their wages the very moment they received them, fuelling further inflation and necessitating more printing of notes to pay 250 billion reichsmarks for a kilo of butter or 15 billion for a short ride on a Berlin streetcar. The only way to deal with this situation was demonetisation: purging the system of all existing notes and launching a new currency backed by solid assets — in this case, land belonging to the state. With credibility restored, inflation fell and the run on the currency, too, ended.

We could similarly cite Boris Yeltsin’s Russia, which, on January 1, 1998, redenominated its currency, with a ‘new’ rouble being made equal to 1,000 ‘old’ roubles. North Korea, under its erstwhile Supreme Leader Kim Jong-il, did the same on November 30, 2009, by creating a ‘new’ won equivalent to 100 ‘old’ wons. The intended goal again was to address rampant inflation and restore credibility in the local currencies that had even become unwieldy for conducting transactions.

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But unlike in Germany, both these experiments of simply lopping off zeros from banknotes met with little success. 1998 turned out to be the great Russian financial crisis year. The ‘new’ rouble’s exchange rate, which was 5.96 to the dollar on January 1, collapsed to 20.65 when the year ended, with consumer price inflation also soaring to 84.5%. In North Korea, rice cost about 2,000 won/kg before redenomination. By August 2011, the price was back to 2,000 won/kg, except that this was in the new currency redenominated at 100:1!

The Narendra Modi government’s demonetisation of Rs 500 and Rs 1,000 banknotes — constituting over 86% of the total value of currency in circulation — is remarkable because it hasn’t been undertaken in response to any hyperinflation or loss of confidence in the rupee. The rupee has actually been quite strong, both in terms of its internal as well as external value. Annual consumer price inflation was just 4.2% in October, while the rupee has held steady at Rs 66-68 against the dollar for the last one year and more. In real effective terms — against a basket of 36 currencies after adjusting for inflation differentials vis-à-vis the countries concerned — the rupee’s average trade-weighted exchange rate in October was the strongest since July 2011.

Simply put, the Modi demonetisation does not follow the conventional logic of a currency ‘stabilisation’ measure; the Indian economy is hardly suffering any hyperinflation or run on the rupee today to even remotely warrant such an action. It has, instead, been projected as a ‘structural reform’, targeted at reshaping public attitudes towards currency with a view to move towards a cashless economy. That, by itself, is a laudable goal. In India, most economic transactions take place in cash outside recorded market channels and hence go largely untaxed. This — apart from fostering a parallel ‘black’ economy with obvious security implications — prevents the government from investing sufficiently in public goods to pursue long-term growth and equity objectives. Demonetisation, if anything, sends out a clear message that cash is no longer cool and should, perhaps, also be seen with the other planned big reform — of instituting a nationwide goods and services tax regime, which is also ultimately aimed at raising the country’s abysmally low tax-GDP ratio.

WATCH VIDEO: How Demonetisation Impacts Rural Population

But although intended as a ‘reform’ measure, the Modi demonetisation is likely to have more of a ‘stabilisation’ impact — with the difference that we are talking of an economy which was far from overheated and experiencing hyperinflation or speculative attacks on its currency. On the contrary, the economy was already in slowdown mode and starved of investments, forcing even the Reserve Bank of India (RBI) to significantly loosen its monetary policy stance of late. Demonetisation would willy-nilly lead to unprecedented monetary tightening, with nearly Rs 15 lakh crore worth of currency being withdrawn overnight from circulation. This untimely, and probably unintended, ‘stabilisation’ has the potential to convert a slowdown into a full-blown recession.

The Modi government has said that the withdrawn Rs 500 and Rs 1,000 denomination notes will be replaced with new currency with enhanced security features. But that’s easier said. To start with, printing itself — the total demonetised banknotes numbered 2,300 crore pieces — may take 5-6 months, according to various estimates. Even after printing, the new currency has to be delivered to bank branches and ATMs not just in Delhi and Mumbai, but to even Robertsganj, Dantewada, Nabarangpur, Leh, Cherrapunji and Kohima.

There is an additional aspect that needs highlighting. Out of the Rs 17.54 lakh crore worth of outstanding notes in circulation as on October 28, only Rs 4.84 lakh crore, or 27.6%, was held by scheduled commercial banks as cash in hand and balances with RBI. The remaining amount would have been mostly with the public, repeatedly changing hands, and with each transfer resulting in a good/service getting produced or exchanged. 86% of such circulating money being suddenly immobilised is a huge thing, especially when every Rs 500 or Rs 1,000 note gets used for not one, but several transactions. If one considers the whole cycle — from printing and transporting the new currency across the length and breadth of the country, to its being actually withdrawn by people — it could take at least a year for liquidity, expressed as both quantity of money and velocity of circulation, to regain its pre-demonetisation levels.

All this makes for a unique demonetisation never attempted before — not for ‘stabilisation’, but as ‘reform’. The consequences, whether intended or otherwise, may not take too long to reveal themselves.

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