The demonetisation of ₹500 and ₹1000 bank notes was a step taken by the Government of India on 8 November 2016, ceasing the usage of all ₹500 and ₹1000 banknotes of the Mahatma Gandhi Series as a form of legal tender in India from 9 November 2016
The Prime Minster of India declared circulation of all ₹500 and ₹1000 banknotes of the Mahatma Gandhi Series as invalid and announced the issuance of new ₹500 and ₹2000 banknotes of the Mahatma Gandhi New Series in exchange for the old banknotes.
The banknote denominations of ₹100, ₹50, ₹20, ₹10 and ₹5 of the Mahatma Gandhi Series continued to remain as legal tender and were unaffected by the policy. The demonetisation was done in an effort to stop the counterfeiting of the current banknotes alleged to be used for funding terrorism, as well as to crack down on black money in the country. The move is also aimed at reducing corruption, drug menace and smuggling.
Background
Similar demonetisation of banknote denominations have been taken in the past. In January 1946, banknotes of 1000 and 10000 rupee were withdrawn and new notes of 1000, 5000 and 10000 rupee were introduced in 1954. The Janata Party coalition government had again demonetised banknotes of 1000, 5000 and 10000 rupee on 16 January 1978 as a means to curb counterfeit money and black money
In 2012, the Central Board of Direct Taxes had recommended against demonetisation, saying in a report that "demonetisation may not be a solution for tackling black money or economy, which is largely held in the form of benami properties, bullion and jewellery"
On 28 October 2016 the total banknotes in circulation in India was ₹17.77 lakh crore (US$260 billion). In terms of value, the annual report of Reserve Bank of India (RBI) of 31 March 2016 stated that total bank notes in circulation valued to ₹16.42 lakh crore(US$240 billion) of which nearly 86% (around ₹14.18 lakh crore (US$210 billion)) was ₹500 and ₹1000 banknotes. In terms of volume, the report stated that 24% (around 22.03 billion) of the total 90266 million banknotes were in circulation
While the supply of notes of all denominations had increased by 40% between 2011 and 2016, the ₹500 and ₹1000 banknotes increased by 76% and 109% respectively in this period owing to forgery. This forged cash was then used to fund terrorist activities against India. As a result the decision to eliminate the notes had been taken
.Reactions
The decision met with mixed reactions Several bankers like Chairperson of State Bank of India, MD & CEO of ICICI Bank and Chairman of HDFC appreciated the move in the sense that it would help curb black money.
Finance Minister said that demonetisation would clean the complete economic system, increase the size of economy and revenue base. He mentioned the demonetisation along with the upcoming Goods and Services Tax (GST) as an attempt to change the spending habit and lifestyle
Effects of Demonetization, short and long term.
1. Immediate impact: is expected to be negative all round:
a. In the short term it will be a logistical nightmare to manage the cash replacement in banks and smooth functioning of the banking system.
b. slowdown in consumer spending due to limited cash availability.
c. severe liquidity issues in cash based sectors like Real Estate and Jewellery.
d. GDP will decline in the next 2 quarters due to reduction in overall spending.
2. Over the next 4-5 months:
Those having legitimate income will deposit it in banks and apart from the initial hassles associated with the banking system, they will have nothing to worry about.
However those having unaccounted money will face several problems as follows:
a. Those who choose to do nothing with the money, their notes will expire worthless. Every note is a liability of the Government (RBI), and thus notes becoming worthless will benefit the Government by extinguishing its liability.
b. Those who declare their unaccounted money, approx 60- 70% of the money will go to the Govt in the form of taxes and penalties.
c. There will be a third category who will try to launder their money, but which will entail severe risks including penalties and prosecution. However, the money sought to be laundered will anyway enter into circulation and remain therein.
It is expected that even if 50% of the around 14 lakh crores of old notes are legitimate, the remaining 50% or around Rs 7 lakh crores of unaccounted money will see around 60 to 80 % thereof or approx Rs 5 lakh crores coming to the government in the form of extinguished RBI liability (point a above) and taxes and penalties. This Rs 5 lakh crores is enough to take care of India's entire fiscal deficit for one year or more.
3. Overall Economic Impact:
a. GDP growth is expected to be negative for around 6 months. However subsequent 2 years will see sharp "hockey stick" revival in growth.
b. Inflation is expected to fall sharply with fall in Real Estate prices and transaction costs thereof.
c. Government Deficit will see a huge windfall in the next 2 years.
d. Currency is expected to strengthen as inflation drops and economy gets a boost.
e. Banking System will get a boost, as around Rs 7-8 lakh crores base money (new legal money) will enter the system, which will further create around 3-4 times more money due to re-circulation.
f. Real Estate and Jewellery sectors, though battered initially will stabilize in the next 6 months.
4. Effect on various Asset classes:
a. Bond prices will rise as interest rates drop.
b. Real Estate is expected to fall by around 20 -25 % and stabilize thereafter.
c. Effect on Gold is a bit uncertain, and may be neutral/ negative. Lower black money will depress demand, but at the same time Gold is a hedge against uncertainty and those still wanting to park black money may prefer to put it into Gold instead of cash.
d. Equity is expected to benefit the most due to three reasons. One, there will be a gradual shift from physical assets (real estate/ Gold) to financial assets. Two, the organised sector (corporates, expecially listed ones) will benefit due to less cash transactions. Lastly, lower inflation and interest rates will benefit listed corporates through lower borrowing costs, thereby increasing their profitability and valuations.
Thus Asset Allocation and re- balancing thereof will now play an even more important role, making proper financial planning imperative.
Lastly, the question may arise as to whether the new Rs 2000 Rupee notes will create more black money or not. While that is always a possibility, it should be noted that this demonetization would have created a psychological impact especially on large scale evaders who will definitely think twice before taking such action.
