A curious thing is happening in India right now that the financial news media has picked up on in pieces but I have found it difficult to grasp the entire story so I did a little digging to figure out what is happening there. Luckily, Cash Chronicles also has a friend on the ground in India to help us make sense of what is happening as well.

Essentially the government announced last week that it was banning all 500 and 1000 rupee denomination notes and that these would cease to be legal tender by December 30^th of this year. In addition, the government introduced new 500 and 2000 rupee notes. The announcement was made by the Prime Minister of India Narendra Modi in an unscheduled live televised address to the nation at 20:15 Indian Standard Time on November 8^th. This demonetization of the currency was done in an effort, it was claimed, aimed at stopping the counterfeiting of the current banknotes allegedly used for funding terrorism, as well as a crackdown on black market money in the country.

According to figures provided by The Indian Express newspaper and my own calculations, the value of these bills in circulation amount to about $206 billion dollars. Imagine the potential chaos of the effect of taking $206 billion out of the US economy. Now imagine having a society that uses cash much more frequently than we do here, multiplying the population 4 times and doing it all in 6 weeks and that is essentially what you have in India and it seems to be producing a lot of chaos.

The story piqued my interest when I saw headlines yesterday on Bloomberg of The Strange Consequences of India’s Banknote Ban in which many strange occurrences are highlighted such as defense jets on standby ready to ferry cash to remote areas, banks reaching out to religious institutions in order to get small change, selling out all the rolex’s in one store in Mumbai in one day, to ATM’s running out of cash all over the country.

The Reasons and a Little History

However the mainstream news media here in the West hasn’t really done a good job in summarizing why this is happening. I have always been fascinated by monetary economics and the crazy behaviors it can induce in people when a decision like this is made. First we have to understand why they made the decision to take away these notes. The goal here as the government claims, is to weed out tax evasion and corruption. Bloomberg claims that unaccounted for money makes up nearly a fourth of the economy there. India also seems to have a bit of a history of this type of demonetization, the government has demonetized notes in the years 1946, 1954, and 1978. Each time this was for the goal to curb counterfeit money and black market money.

There also seems to be some history behind the reason that it was kept so closely within the government and announced as a surprise. Apparently in early 1970’s, a committee had recommended taking certain notes out of circulation to discourage illegal activities but the announcement received so much press that, black market dealers, switched to lower denomination currency to avoid the recall. However, no matter what economists are saying in that it will help discourage illegal behavior long term, it doesn’t seem to be having the long term effect that the government is intending if they have to demonetize the currency every 30 or so years.

On a conceptual basis I find this reasoning hard to believe as well, with a good example of why it doesn’t work being the recommendation of the committee in the early 70’s which induced black market dealers to switch their means but not their ways. The only plausible argument in support of this demonetization is if there has been widespread counterfeiting of the notes. Any central bank would find its policy tools weakened or useless if widespread counterfeiting is taking place. This could also produce a lack of confidence in the currency itself which could produce a death spiral for the currency when the population turns to other currencies to supplant the local one as has been the case in the past in countries like Ecuador. However this isn’t the case in India, if there is widespread counterfeiting, the government seems to be concerned with the counterfeiting of just 2 notes which is manageable.

How It is Being Carried Out and The Aftermath

Either way, the plan on how to carry this out is probably causing the most chaos. More than just simply being able to go to the bank and exchange your old notes for new ones, the government also laid down a set of rules and capital controls for the implementation of the exchange.

Source: onepromocode.com and author’s calculations

In addition, many people in India do not have any bank accounts at all, they just deal strictly in cash: paid by their job in cash, do all their daily spending in cash and if they can, save in cash. For these people it is a real and serious race against time to get rid of their 500 and 1000 Rs notes. I can only imagine how some people would react, if they dealt only in cash all the time, had no bank account and suddenly found their cash worthless and were limited to getting $58.77 per day.

Well there you go

State run banks have been calling employees out of retirement (who knew this was an option?) who have been working long hours without breaks and the government has told these lenders to supply the workers with transportation and food.

According to our friend on the ground, there was such secrecy around this decision that the banks did not know either. Bank lines have been horrendously long. She tried to exchange 6500 Rs in old notes at Citibank and was turned away because in addition to the above restrictions, the government has also issued guidance on who gets priority in exchange of the old notes:

1. Foreign tourists
2. Indian National Residents
3. Non-Resident Indians

No option was offered for foreign nationals who are residents in India. I didn’t ask if she would have been able to use her US passport to just pose as a tourist and get the new notes anyway, but if she did try this, it didn’t work. Most ATM’s have been broken or have been out of cash for days on end. The big hypermarkets are the only establishments that take credit, local stores, restaurants and even her company cafeteria only take cash so as she relayed her story she was sitting hungry at work with no cash to speak of.

However, she did mention that what has amazed her about the whole ordeal is that how much everyone she has talked to locally supports the initiative. This may have been due to a reluctance to criticize the country in front of a foreigner, but reminded her of some of the dictatorships in the Middle East the way people were heaping praise on Prime Minister Modi.

The Real Reason Behind it All?

However one of the positive effects of this policy may be the real reason behind the announcement and the way it is being carried out. If you notice on the graphic of the exchange rules, there is no limit on the notes that can be deposited. In other words this action provides a strong incentive for people who never have before had one, to open a bank account for the first time. According to www.livemint.com, the policy is sparking a surge in cash deposits and is raising hopes that added liquidity for the banks will allow banks to lower lending rates more aggressively in order to boost the economy. The economy grew at a 15 month low in the second quarter of 2016 and this action seems to be having the effect of a backdoor interest rate cut.

The State Bank of India (SBI) said it received $2.68 billion in savings and current account deposits since the announcement. Not coincidentally, SBI shares also surged 11.3% the day after the announcement. If this really is a means the government has used in order to pre-empt an interest rate cut by the central bank (essentially making this a back door interest rate cut), boost the economy and maintain government popularity, I have to say this is a pretty ingenious move. There are more sinister interpretations to be had from this that people will surely make, such as did the banks have a hand in influencing this decision since they had so much to gain from it?

A quick look at Indian interest rates for the last 3 years show there isn’t as much evidence for the back door interest rate cut argument since interest rates have been falling since 2015.

And inflation has been relatively stable by high growth country standards.

What I suspect is that this was more of a monetary stimulus aimed at boosting growth, pushing liquidity towards the banks and lowering interest rates without actually lowering the prime rate.

Time will definitely tell how this plays out for the country and the economy. India is going to be needed to be a strong source of growth not just for its people and neighbors but for the world in the coming decades. With the developed economies stuck in slow growth mode, China with its government restrictions on private capital and countries starting off on a more nationalistic and protectionist mood, a growing, large and opening democracy is hoped to be one of the bright spots for the world economy. Let’s hope this move just proves to be another bump in the road in its growth story.

 

 

The information provided by www.cashchronicles.com is for informational purposes only. It should not be considered legal or financial advice. You should consult with an attorney or other professional to determine what may be best for your individual needs. www.cashchronicles.com does not make any guarantee or other promise as to any results that may be obtained from using our content. No one should make any tax or investment decision without first consulting his or her own financial advisor or accountant and conducting his or her own research and due diligence. To the maximum extent permitted by law, www.cashchronicles.com disclaims any and all liability in the event any information, commentary, analysis, opinions, advice and/or recommendations prove to be inaccurate, incomplete or unreliable, or result in any investment or other losses. Content contained on or made available through the website is not intended to and does not constitute legal advice or investment advice and no attorney-client relationship is formed. Your use of the information on the website or materials linked from the Web is at your own risk.