Thursday, November 10, 2016

Understanding the Phasing Out of Higher Denomination Fiat Currency in India

By Rahul V Kumar*

The Government of India has decided to phase out the existing higher denomination (500 and 1000 Rupees note) currency from circulation. Many have hailed this decision as an important step to eliminate black money from the system. At the broadest level, I put forward a hypothesis that the decision has many possibilities to strengthen the role of the state. A stronger state has its own consequences on individual freedom and liberty. This, in turn, has more potential to create an unstable monetary environment in the long term. Given the distant possibility of a complete wipe out of black money, there are a few immediate considerations that are worthy of analysis. Arbitrary and quick decisions from the side of the government will be carefully observed by the business community. This could lead to precautionary measures adopted by these groups in future to avoid discretionary government decisions like the present phasing out.

Arbitrary and dramatic decisions could lead to distrust in government handling of money supply in the economy. Lack of trust in fiat currency could have negative impact on the banking system and the control of credit by the government. Distrust of business in the currency system, however, could be seen as a positive step towards the rise of newer forms of decentralised currencies in the country. Online monetary exchanges and crypto currency would be used for future business transactions. But, the broader consequence of increase in demand for plastic currency and crypto currency could be to transfer illegality from paper currency to plastic currency sector, until the existing monetary institutions are allowed to undergo positive transformations. Credit and debit card frauds, which are increasingly reported, are likely to expand. An illegal economy in online transactions is likely to thrive.

Illegality in currency arose primarily because an artificial demand was created for paper currency by making it fiat money. The hypothesis of the current decision was that all the fiat currency and illegal notes of higher denomination stored in vaults and in circulation will be affected. The possible surge in demand for lower denomination currency was predicted and steps taken to deal with it. The heterogeneity of the country, the differential growth rates of different states, inequalities within these states, sectoral differences and so on make any analysis of the impact of policies in India difficult. Different people perceive the impact differently.

An important consequence of wiping out higher denomination currency is that production in the economy is likely to be affected in the near term. All activities that were supported and carried out using illegal money will immediately come to a halt. How the economy copes with this situation should be speculated. The coping strategies would result in a surge in the demand for employment. In the absence of development of suitable employment opportunities, it is likely that the government will find new avenues to intervene in determining economic opportunities. In other words, reaction in the business sector would be reflected with a strong rise in the government sector.

To prevent crime in the economy requires a broader canvas to determine the origin of the crime. Crime in fiat money originated, when fiat money was made valuable. This has origins in how the states evolved and gained control over monetary transactions. Hence, the new policy can be seen only as a strategic move by the current government, which converted a long-term problem in the monetary system into a political opportunity. It need not correct the flaws in the system.

*The Author is Research Consultant at Centre for Public Policy Research. Views are personal and does not represent that of CPPR