Demonetization and Internal Security of India : by IPS Officer Lohit Matani

This Article is a part of a series of Articles on Internal Security and Disaster Management by Lohit Matani. You can check his future Articles by visiting by this page. The Articles would come every Sunday.

Hi friends!

I have a deep interest in Internal Security, Disaster Management and Case Studies on above topics, and I will try to cover the above topics for Mains 2017.

One of the recent developments in this topic is the impact of demonetization on Internal Security. Below, I have made an effort to describe the impact of demonetization on Internal Security, corruption and other economic indicators. I have also given a brief on some international experiences of demonetization across the world.

1. A brief Introduction – Prime Minister’s Historic Address
2. What is Demonetization with reference to India?
3. Impact of Demonetization
4. Dynamism Shown by the Government
5. Demonetization Experience in Different Countries
   

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A Brief Introduction- Prime Minister’s Historic Address

On the evening of 8^th of November, 2016, Indian Prime Minister Mr. Narendra Modi gave a message to the public on television. The message was regarding ending the scourge of black money and other problems from the Indian society, economy and polity. In a historic move, he declared that the five hundred and one thousand rupee notes will cease to be legal tender from the night of 8^th November, 2016. On the other hand, two thousand rupee notes and new notes of five hundred rupees will be placed in circulation.

He said that the move will strengthen the hands of the common in fighting against corruption, black money, money laundering, terrorism and financing of terrorism as well as Fake Indian Currency Notes (FICN).

Fully sensitive to some of the difficulties the common citizens may face in the coming days, the Prime Minister also announced a series of steps that will help overcome the potential problems. Persons holding old notes of five hundred or one thousand rupees were allowed to deposit these notes in bank or post offices from 10th November onwards till 30th December. There were also some limits placed on the withdrawals from ATMs and bank for the very short run.

Shri Modi stated that on humanitarian grounds notes of five hundred and one thousand rupees will be accepted at government hospitals, pharmacies in government hospitals (with prescription of a doctor), booking counters for railway tickets, government buses, airline ticket counters, petrol, diesel and gas stations of PSU oil companies, consumer cooperative stores authorized by the state or central government, milk booths authorized by state government and crematoria, burial grounds.

In his address the Prime Minister shared the insight into how the magnitude of cash in circulation is linked to inflation and how the inflation situation is worsened due to the cash deployed through corrupt means. The Prime Minister added that it adversely affects the poor and the neo-middle class people. He cited the example of the problems being faced by the honest citizens while buying houses.

What is Demonetization with reference to India?

Demonetization means the withdrawal of old Rs 500 and Rs 1000 notes, as official modes of payment, by the Reserve Bank of India. According to Investopedia, demonetization is an act of stripping a currency of its status as a legal tender. Following it, the notes of Rs 500 and Rs 1000 won’t be used as a medium of exchange of goods and service in India.

The total value of old Rs.500 and Rs.1000 notes in the circulation is to the tune of Rs.14.2 trillion, which is about 85% of the total value of currency in circulation. This means that the total cash has to now pass though the formal banking channels to get legitimacy. The World Bank in July, 2010 estimated the size of the shadow economy for India is at 20.7% of the Gross Domestic Product (GDP) in 1999 and is rising to 23.2% in 2007. Assuming that this figure has not risen since then (quite unlikely though) and that the cash component of the shadow economy is also proportional (it could be higher), the estimated unaccounted value of the currency could be to the tune of Rs.3.3 trillion.

Now, post the announcement of demonetization by the government this money would have to either accounted for by paying the relevant tax and penalties or would get extinguished. There are higher chances of larger proportion of this unaccounted currency getting extinguished as the tax rate and subsequent legal issues could be prohibitively high for such money.

Impact of Demonetization

• Impact on Money Laundering and Terrorism Financing

Topic 2.8 of the book deals in detail with the financing of terrorism in India. In it we have understood that supply of Fake Indian Currency Notes (FICN), and money laundering are two main medium of financing of terrorist activities and groups. The movement of money to the terrorist organizations happens through the following medium:

1. Moving money by using financial system including transfers through hawala or other similar mechanism of illegal, informal transfer of funds in bulk.
2. Physical movement of money through cash couriers and use of FICN.
3. Use of international trade system in high valued items like diamonds and gold through money laundering.

Often the money used by the terrorist organizations is the unaccounted money and the organizations involved in their movement cannot disclose their source to the law enforcement agencies. The majority of the money with the terrorist organization is in the form of old Rs 500 and Rs 1000 notes. After the demonetization step, all the wealth with these organizations has become invalid. As a result, funding of their activities has become difficult.

The novel step has also curbed future funding of terrorist organizations. The demonetization step will either suck back all the unaccounted money into the banking channel or make it invalid after 30^th December, 2016.  Government is also taking adequate steps to monitor the movement on new currency notes through the banking channel. Any suspicious transaction involving a large amount of money without disclosing the income source would be traced by the law enforcement agencies. Agencies like Enforcement Directorate, banks and Financial Intelligence Unit are geared up to trace any new transaction suspicious to be aimed at terror financing.

Moreover, the new notes have additional security features as mentioned in topic 2.8 of this book. By the step, the old FICN notes have become invalid and can no longer be used for terror financing. The security features of the new notes are difficult to copy. Moreover, the responsible agencies are well prepared to fight counterfeiting of these new notes and their trafficking into the Indian economy.

Once money laundering is curbed, terrorists won’t be able to use the international trade system in high value items as the money movement would be curbed in the manner described above.

Table A1 shows how demonetization will impact various methods of terrorism financing.

• Impact of Demonetization on Black Money
  

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After the demonetization step, all the black money owners will not be able to deposit their old Rs 500 and Rs 1000 notes in the banks, as won’t be in a position to give an account of that to the Income Tax authorities. Thus, the black money held by them will lose its significance and India will come out from the problem of black money in the long run.

• Impact of Demonetization on Criminal Activities and Corruption
  

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As the amount of black money and unaccounted money will decrease, the financing of illegal activities will become costlier. Thus it will become costly to conduct illegal activities like drugs trafficking, organized crime and human trafficking. It will also make collusive corruption most costly as unaccounted and black money would no longer be available to be used in it. Like this, the rate of corruption will decrease in the long run.

• Impact of Demonetization on Economy
  

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As a large amount of money will be deposited in the banks and the unaccounted money will get extinguished, following impacts will happen on the Indian economy:

1. It will enhance the liquidity position of banks, which can be utilized further for lending purposes. It will decrease the lending interest rates.
2. With cash transactions facing a reduction, alternative forms of payment will see a surge in demand. Digital transaction systems, E-wallets and apps, online transactions using E-banking, usage of Plastic money (Debit and Credit Cards), etc. will definitely see substantial increase in demand. It will lead to a cashless economy in the long run.

• It will increase the demand for gold as people may start having more faith on gold than Indian currency notes.

1. As the amount of currency in hand will decrease, the inflation is expected to go down in short run.
2. The property prices will come down as the real estate sector involves circulation of a large sum of black money at present.
   

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• Short Term Impacts
  

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The step of demonetization is aimed at creating many long lasting positive impacts, but in the short run the country has suffered and will suffer from certain negative impacts. There will be a disruption in the current liquidity situation as households are likely to get affected by the note exchange terms laid by the government. Unorganized sector proceedings including small trade market activities will remain volatile in the short-term. It is important to note that a significant percentage of the Indian workforce is employed in this sector which is likely to be affected by immediate liquidity issues. Overall, negative impact on disposable income is expected along with likely disruption in the consumption patterns of the general populace.

Dynamism Shown by the Government

The government has recognized the hard ships faced due to the demonetization step and has shown great dynamism in dealing with it. The government machinery is continuously monitoring the ground realities and taking daily decisions in dealing with them. Some of the dynamic steps taken by the government in dealing with the hardships are:

1. Old notes can still be exchanged at the Reserve Bank of India.
2. Government has extended the date (considering the ground realities) for the use of old Rs 500 note at petrol pumps, government hospitals, and some other public utilities till a prescribed date.

• Seeing the liquidity crunch, government also exempted the citizens from paying toll taxes till a prescribed date.

1. Government allowed old currency in school fees, colleges, pre-paid mobile top-ups, purchases at consumer cooperative stores, at international airports, etc.
2. Government abolished withdrawal charges at all ATMs.
3. Seeing the situation, government increased the daily withdrawal limit in ATM from Rs 2000 to Rs 2500.

• Government set up a task force under the chairmanship of RBI deputy governor S S Mundra, to make sure ATMs across the country become ready to dispense higher denomination notes in the shortest time.

The above and other steps were taken on a daily basis after analyzing the ground impact of demonetization. This shows the seriousness of government for implementing this breakthrough reform.

Previous Efforts of Demonetization in India

1946: Winston Churchill introduced Rs 10,000 bill which helped the rich in hoarding money at the expense of the poor, increasing inflation. The government announced demonetization of denominations above Rs.1000 with effect from 12^th January 1946 and gave little time for exchange. The crown princes were exempted from it and it was valid only to the areas directly ruled by the British Government. The government through this drive collected Rs.134 crore of the total Rs.143 crore available in the market (according to RBI estimates), only Rs.9 crore was not exchanged therefore demonetized. It turned out to become more like a currency conversion drive as the government couldn’t achieve much of profit in the cash-strapped economy at that time.

1978: Higher denomination notes of Rs 1000, 5000 and 10,000 were again introduced in 1954. Due to various historical reasons thereafter, the Indian trade deficit started widening pushing Mrs. Indira Gandhi to devalue Indian currency by 57% in 1966. Finally, the demonetization step was taken in 1978 to overcome the negative impacts of higher denomination notes. However, the measure failed because there were rumors that the demonetization would come into effect sooner or later.

Demonetization Experience in Different Countries

Various countries have, in the past, taken the demonetization step. Their experience is a good learning point for the Indian demonetization story. Experience of some of the countries is as follows:

1969 USA:

Due to the rising menace of black money and corruption, President Richard Nixon demonetized $1000 and above denomination notes. Only bills of value $100 and below were made acceptable. The step succeeded in decreasing black money and criminal activities in USA. Even today $100 bill is the maximum available currency for circulation.

1996 Australia:

Worried by the increasing rate of black money, the Australian government replaced all the paper based currency notes with long life polymer based currency notes with greater security features. This improved the life of the bills and helped in making Australia a business friendly country, despite the initial costs incurred to manufacture polymer-based notes.

2010 Zimbabwe:

Chronic inflation in Zimbabwe forced the government to print higher currency notes of One Hundred Trillion Zimbabwe Dollars and remove the lower denomination notes. The decision was taken in a emergency situation and the government was not well prepared to tackle it. Thus, the step failed and the economy was forced to replace their currency with US Dollars later.