On November 8th, 2016, the government of India announced that the Rs 500 and Rs 1000 currency notes would no longer be recognized as the legal currency. The aim behind this historic move was to combat tax evasion and corruption and to curb terrorism financing. Eliminating large denominations of currency makes it difficult to conceal large amounts of unaccounted cash, thereby making it easier for the government to detect and remove undisclosed income. Historically, there have been two instances of demonetization in India, first in 1946 and again in 1978, but both were against higher denomination notes than the current measure.
Some economists have praised the move and believe it could potentially set India’s economic fortunes on the right track. However, a different subset of economists, including the ex-RBI governor Raghuram Rajan, believe that demonetization has already been tried, and clever people will find ways around it. Here is my take on how the demonetization will affect the Indian economy and its plausible spill-over effects on other global macro indicators.
Effect on Money Supply and Exchange Rates
With the older 500 and 1000 denomination Rs notes withdrawn, the overall money supply in circulation is expected to fall in the near future, as a good percentage of cash, currently held as black money, will not be returned to banks. Furthermore, to the extent that this black money does not re-enter the financial system in any form (gold, real estate, conversion to international currencies, freshly minted fake currency, etc.), there will be a permanent reduction in the overall money supply.
As a consequence of this demonetization process, a recent study estimates that even if 20 percent of the existing Rs 500 and Rs 1000 notes are not replaced with the new currency notes, it will result in a permanent wealth destruction of Rs 3 trillion. This cash cannot possibly find its way to being converted into white, and hence, an easy escape option for the black money holders is to convert their old notes into USD/EUR and other major international currencies.
