What demonetization may mean for the Indian economy

By phasing out INR 500 and INR 1,000 notes, the government’s fight against domestic black money has reached the next level and is sending a strong message to those hoarding cash and transacting in it. This move is also likely to curb the alleged increased circulation of counterfeit currency, which will go a long way in the fight against financing terrorism.

From a business perspective, the move may impact small businesses, as many such businesses deal in cash despite several government mandates to adopt technology to increase transparency. The demonetization will perhaps help achieve this, albeit indirectly, as an immediate outcome of the move is likely to be a rise in individuals and businesses adopting digital technology for financial transactions, propelling India toward a paperless economy. In fact, some digital wallet providers have reported a 100% rise in the number of users[1] who have signed up on their platforms in just one day post the government’s announcement.

These moves toward a paperless economy could mean that every rupee in circulation is accounted for and local black money unearthed. However, this should be coupled with increased robustness and cyber security measures being adopted by banking systems in India. With recent ATM fraud and hacking cases having been reported in the media, security is a concern that needs to be addressed if the economy is required to make the shift to being a plastic, paperless one.

In addition to demonetization, the Financial Intelligence Unit is getting information about large cash transactions from banks, and information on these deposits will eventually be shared with the Income Tax department. This will not only unearth black money but also result in greater tax compliance going forward.

While these are all welcome initiatives, it is important to understand that to fight money laundering, we must try and prevent the generation of black money. India is a large cash-driven economy that frequently facilitates the generation of black money through unrecorded/unreported deals and transactions. This modus operandi is fairly well-known in sectors such as real estate and gems and jewelry. It is important to note that while this initiative will help identify and unearth assets in the form of cash, a significant amount would have already been invested in real estate and/or gold, etc., which may not be unearthed immediately. So while this step would probably put a brake on liquidation of these assets in the short term, we will have to wait to see the effect of the various steps taken by the government on the future generation of black money. Additionally, the goods and services tax (GST) could also be effective in curbing the generation of black money through efficient transaction tracking (of purchases and sales) to ensure that no transaction goes unreported.

While this step of demonetization may prove to be effective in the long run, for an economy that is largely fueled by cash, it will cause a fair amount of disruption and inconvenience in the short term, especially for the poor/middle class and large rural economy where financial inclusion is far from being a reality. While India has witnessed demonetization of large currency notes during the 1970s, this latest step, although not exceptional, has shocked the economy. What we need to ask ourselves is whether the hardships, being faced hopefully in the short term, are worth all the trouble. The answer may, in fact, be ‘yes’.

A version of this post appeared in the Forbes magazine. You can access it here.