Nov 12, 2016

Demonetization - The Missing Link

Indian PM made a highly risky political & economic move by removing 500/- & 1000/- rupee notes from circulation. The move aimed at curbing black money & fake currency seems to be getting equal amount of support & criticism from different quarters at the time of writing.

Currency is the lubricating factor on which economy runs. The Indian currency base as of Mar'16 is represented in the table below

Currency Note     Value ( In Rs Billion)    Volume(In Billion)  Value%     Volume% 
   10                            320                               32                            1.95%       40.8%
   20                              98                                 5                            0.6 %          6.2%
   50                            194                                4                             1.2%           4.9%
 100                          1578                              16                             9.6%         20.1%
 500                          7854                              16                            48%             20%  
1000                         6326                               6                            38.6%          8.1% 

This brings an interesting reading .  The volume of 100 & 500 rupee notes in circulation is almost identical . Assuming that demand for various denominations is a key factor behind printing decisions, there is a huge demand for 500/- rupee notes.  As per the classical economic 'equation of exchange'  ( MV = PQ ) , Monetary base ( It could be M0/M1/M2/M3 )   X velocity of money ( equals GDP .  Over the last few years, velocity of money in India has been decreasing in India, inspite of increase in monetary base.  Government doesn't publish stats as to what is the velocity of money for different currency denominations. But the increased demand of 500/- rupee note coupled with overall decreasing velocity of currency is most likely to be due to the hoarding potential of 500/-  ( and similar case with 1000/-  )  . So, Modi has a justified case - 500/-  & 1000/-  are one of the means in which unaccounted money is stashed away.

Now, how is removing 500/- and 1000/-  going to affect economy. This is where I think the planners did not get their act together. If you remove 500/- and 1000/-  , you are going to remove close to 87% of the monetary base by value & 28% by volume.  You are going to supplant that part of economy by 2000/-  and an increased circulation of 100/-  rupee notes.  Now how many 2000/- and extra 100/- rupee notes are you going to need to get back the monetary base to the same level ?

If you assume that all of the present 1000 rupee notes and say one-half of 500/- rupee notes are going to be replaced with 2000/- , the number of 2000/- rupee notes to be printed works out to be about 5.13 billion notes

The case for extra 100/- is a bit more trickier.  If half of the monetary base of 500/- is converted into 100/-  , the replacement print is going to be about 39.3 billion notes (  current circulation of 100/- as you can see from the table is 16 billion )  .  But this is not so straightforward either.  If someone goes to a shop and gives a 2000/- rupee note for an 800/- rupee product, the shopkeeper needs to give 12 hundred rupee notes in balance.  Now, this is going to put a huge demand for 100/- rupee notes. And it won't be easy for banks /Govt / RBI to cope up with the increased demand for 100/- rupee notes.

Imagine the below red-line ( volume ) as an air-pocket ( economic activities ) trapped under a semi flexible structure.  You are going to pinch the 500 & 1000 into zero, but by opening a 2000/- band and an increased band of 100/- .. The trapped air under the 500/-  and 1000/- would manifest as pressures at 2000/- & 100/-  . The increased pressure on those bands could be equated as a need to print more notes.  Unless the circulation of 100/- notes is dramatically improved , economic activity is going to get hampered seriously .

This is where I feel Government should have acted differently- It should have simultaneously come up with denominations of say 250/-  , 400/- , 750/-  along with recalibrating of ATM's.  Otherwise, doesn't matter how much ever 2000/-  they are going to print. it'll just manifest as increased scarcity of 100/- to the common man & small time traders.  Already the impacts are seen in the economy  where inspite of  the availability of 2000/- , business is not smooth as usual.

Hence, I think this is going to put a serious deflationary effect on economy at the grass root level. On the positive side, real estate prices are going to come down,  cash-less ( cards / wallets ) businesses are going to get a boost .



Anonymous said...

But there is going to be a new 500 note as well

Madman said...

There is an implicit assumption (which is questionable) here. You are assuming that govt will have to replace all the notes in circulation. Given withdrawal limits and also the possibility of hoarders not depositing outgoing notes, the number of new notes required could be much less. Am I missing something?

Ajith Prasad Balakrishnan said...

@ Madman - Yes. Number of notes will be less. How much of that will be needed is a difficult question to answer. It is just a function of supply and demand.. Demand is tightly controlled by withdrawal limits & limited by slowdown in economy.. But the point is that the printing capacity of currency presses is hardly a few millions per day . When the number of notes required are in billions, even if you take a fraction of currency base - say one-tenth ( which would be a very far fetched assumption ) , the days required to replenish currency like this will be easily in many 100's of days