News accounts and analyses on other blogs have usefully described and critically assessed the "demonetization" shock that Prime Minister Narendra Modi gave the Indian economy on November 8. Here we emphasize two features of Modi's initiative that have been little noticed. First, the combination of demonetization followed by "remonetization" will transfer billions worth of US dollars from the Indian public to the Indian government. Second, the skewed pattern in which new notes will be injected will favor some sectors over others.

To recap, Modi announced that, in order to fight untaxed "black money" holdings, the two highest denomination rupee notes would be demonetized the next day (the Rs. 500 and Rs. 1000, worth about $7.50 and $15). Indian citizens have some weeks to deposit the invalidated notes into banks for deposit credit, or exchange them for new valid notes of Rs. 500 and Rs. 2000. But the exchanges can only be made in small amounts (Rs. 2000, or $30, per person per day) for the time being and, as Devangshu Datta points out, "only with identity proofs (which hundreds of millions don't have) and the additional hardship of standing in many queues for many hours." Once a greater volume of new notes becomes available, currency withdrawal limits will be relaxed, but those who deposit more than Rs. 250,000 (about $3676) in old notes face promised scrutiny by tax authorities.

Currency transactions play a huge role in the Indian economy. To list some pertinent facts about the importance of currency in India:

Over 90% of all transactions in India are (or were) conducted in currency.

47% of the population (almost 600 million people) is unbanked, unable to substitute into check-writing or debit or credit card use.

The Reserve Bank of India puts currency held by the Indian public at Rs. 17 trillion, or 62% of M1 (the sum of currency and checkable deposits).

The two invalidated note denominations make up more than 80% of currency in circulation.

Half of India's money stock (80% of 62%) has thus been at least temporarily immobilized. The immobilization imposes special hardship on the unbanked population. About 30% of the population lack even the basic ID required to change old for new currency notes. Those who sell old notes for new in the informal market suffer a loss of around 20% (the exchange rate reported in recent days).

Here we consider three different aspects of India's currency cancellation policy: (1) the effects of transition away from old notes, (2) the fiscal impact of transition into new notes, and (3) the impact of the non-uniform injection of the new notes into the economy.

1. Effects of transition away from old notes

Modi's surprise announcement imposes a one-time wealth loss on currency holders who are unable or unwilling to convert their entire holdings of old notes. This is actually intentional, because the idea is to eliminate untaxed or illegally gotten wealth held in currency.

Modi seems to have underappreciated, however, that in so doing his policy creates a serious shortage of currency. This shortage blocks ordinary currency transactions, blocking honest ordinary people from making a living, thus reducing national income. The biggest impact is on the poor, who have few substitutes for cash transactions. In the last two weeks, some daily wage laborers have not been paid due to the currency shortage, and are down to only one meal a day because of the drop in earnings. Farmers and vendors unable to sell fresh produce have lost their entire stock of perishables. Other small businesses are unable to operate without access to sufficient new currency notes. And since November 9, close to 50 deaths have been attributed to the currency shortage. A policy ostensibly intended to inflict losses on tax evaders and criminals is imposing, at least in the transition, much greater losses on honest users of currency.

2. Fiscal impact of transition into new notes

While these harms of the transition away from the old notes have been widely noted, hardly any attention has been paid to the implications of the transition into the new notes. The most striking implication is that the Indian government enjoys a one-time revenue gain. Suppose that, as the government purports to believe, a large share of the old currency is "black money" held by tax-evaders and professional criminals who will be penalized by the cancellation because they do not want to face the scrutiny that will accompany the exchange of too many old notes for new. They will simply eat their losses. For the sake of a dramatic example, let's suppose that half of the invalidated currency notes is never turned in. This would mean that the currency stock will fall by 42.5%, or Rs. 7.2 trillion ($106 billion), as the old notes lose their circulating status. The fall in the public's actual currency holdings below its desired level gives the Indian government a huge potential revenue windfall: it can issue replacement currency (the new Rs. 500 and Rs. 2000 notes) of up to Rs. 7.2 trillion in value, without raising the currency stock or the price level above pre-reform heights. (The demand for the new currency may fall shy of Rs. 7.2 trillion at the current price level, because the transition has lowered the public's wealth, and because the public's trust in rupee notes has been diminished.) It can spend these new notes into circulation on government programs or sovereign debt buy-backs. To make the example somewhat less dramatic but still large, if 20% of the old notes are never turned in, the government's revenue windfall is up to Rs. 2.9 trillion ($42.5 billion).

The destruction of the private wealth of non-redeeming old-note holders, combined with the revenue windfall to the government, makes the currency policy effectively a large capital levy, a massive one-shot transfer of wealth from the private to the public sector.

3. Impact of the non-uniform injection of the new notes into the economy

The third aspect to the demonetization we want to mention relates to the effects of the evident unevenness of the injection of new currency notes into the economy. Monetary economists call these "Cantillon Effects." New currency notes are presently entering the economy through the formal banking system under Reserve Bank of India regulation. The notes injected this way are taking time to reach the 600 million Indians who do not have bank accounts. In the meantime, with currency-dependent sellers of goods and services having lost their unbanked customers, those who receive the new currency notes first can buy goods and resources at depressed prices. The terms of trade turn against the unbanked sector, and the relatively wealthy banked population receives a transfer from the relatively poor unbanked population. The skewing of relative prices and incomes will persist until the access to new currency notes flows throughout the economy.

There is also a geographic skewness. Tea vendors in the city of Mumbai, for example, where new currency is appearing relatively promptly, are less hard-hit than tea vendors in the rural villages of Maharashtra.

The currency shortage may also cause structural imbalances in the economy for longer production processes. For instance, mid-November is the sowing season for the Rabi (winter) crop in India, which is harvested in spring. Farmers lacking access to valid new currency notes have been struggling to pay for seeds to sow during this crucial time. Farmers who thereby miss the sowing season will lose their entire year's earnings, even though the shortage of notes is temporary. Industries supported by farmers (fertilizers, machinery, etc.) will also see a fall in demand, and earnings. The relative price changes may persist until spring, at the time of harvest, even if the shortage of currency is resolved sooner. Close to half of Indian families are engaged in agriculture, and it accounts for 16% of the GDP. The government yielded to obvious necessity last week and announced that it would grant farmers a special dispensation allowing them to use old 500 rupee currency notes through the sowing season. But similar problems arise in other lines of business, which the government cannot anticipate and make timely exceptions for. Another example is construction, an almost entirely a cash-based industry, where current projects are being postponed until new currency notes become sufficiently available. This postponement will have effects on housing supply and prices for several years ahead.

Supporters of the demonetization policy have (with or without accounting for all these harmful effects) argued that all together this is still a small price to pay for tackling the big problem of black money. As critics have pointed out, however, the note cancellation really won't do much to fight tax evasion, corruption, or illicit commerce. It will hardly touch most "black wealth," because the financially sophisticated already hold their illicit wealth in other forms: real estate, corporate shares, foreign bank balances, foreign currency notes, gold. The planned re-introduction of large notes will soon re-enable unreported large currency transactions. The tax system that invites evasion, and the political system that invites corruption, remain in place.

We tend to agree with Kelkar and Shah's argument that the sensible ways to reduce the role of black money are through deregulation (fewer bribes to be paid in cash) and structural reform of India's tax and capital controls system (fewer transactions to be hidden using cash). The wealth transfer to government may help to explain Prime Minister Modi's enthusiasm for the currency cancellation and re-issue, despite its likely ineffectuality against black money.

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Co-authored with Shruti Rajagopalan, Assistant Professor in Economics at Purchase College, State University of New York, and Fellow at the Classical Liberal Institute, New York University Law School.