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On November 8th, Narendra Modi’s government declared that ₹500 and ₹1000 banknotes would cease to be legal tender from midnight, suddenly demonetizing 86% of the total value of the currency in circulation. Citizens have until December 30th to exchange their old banknotes, with direct cash exchanges being restricted to ₹2000 per person ($30) and the rest being credited to bank accounts.
Deposit account credits exceeding ₹250,000 ($3,700) will be liable for tax investigation. ATM cash withdrawals are restricted and many machines still need recalibrating to dispense the new ₹500 and ₹2000 notes. Several machines have already run out of notes. This strong move, aimed at tackling corruption, tax evasion and counterfeiting, has led to a sharp fall of the currency in circulation, as shown on the graph below.
In a country where 98% of transactions are cash-based (PwC estimate), and the shadow economy accounts for 25% of GDP (World Bank estimate), or the equivalent of Belgium’s GDP, the cash shortages resulting from demonetization will weight on economic growth. Given the absence of current economic data, accurately evaluating the extent of the impact is difficult.
However, the repercussions should be temporary and dissipate as the economy remonetizes. Moreover, in the medium term, if the government’s decision results in some of the economy exiting the shadows, this will improve public finances.
The government’s move may also spark a switch by citizens from a costly cash-based system (storage, transport, time) towards banks and promote financial saving instead of investments in physical assets (property, gold), which could have positive effects on growth.
The opinion expressed above is dated November 29th, 2016 and is liable to change.
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