Economics and finance, Government and governance, National security | Asia, South Asia

18 November 2016

Cash and crime go hand in hand, with big banknotes contributing to corruption and powering the black economy. But India’s currency changes may create unintended consequences, Kaushik Bhattacharya and Sunny K Singh write.

Recently, India’s government decided to withdraw Rs.500 and Rs.1000 currency notes. The suddenness of the decision has taken India by surprise. While many have severely criticised the decision, some have hailed it as a brilliant move to uncover black money.

The close relationship between large denomination currency notes and the black economy is well established. For example, criminals (and more recently, terrorists) are known to be major users of large denominations like the US$100 bill or €500 note. Common sense, therefore, suggests that increasing the use of alternative modes of payment like cheques, cards or Internet-banking, reduces corruption and ushers more transparency into an economy. Our research, using annual panel data of 54 countries for the period 2005-2014, seems to support this common wisdom. We found that greater reliance on large denomination notes, inter alia, is positively associated with more corruption in an economy.

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In India’s case, there is an additional problem relating to the forgery of large-value notes. Indian intelligence agencies suspect that these forged notes are being circulated in India with the help of a foreign power. Thus, there appears to be good merit in the decision of the Indian government.

The policy, however, could be criticised on several grounds. First, the Indian government has decided to reintroduce currency notes of large denominations (including the Rs.500 and Rs.2000) with increased security features. Our study suggests that with their reintroduction, it is likely that black money will rear its head again. Further, we fear that the possibility these notes will be forged again cannot be ruled out – especially if a foreign power is involved.

Second, the currency system in India, as in other parts of the world, is under the purview of the central bank. While legally the government can intervene in the working of the central bank, interventions of this nature are generally not considered desirable. At present, it is unclear the extent to which the Reserve Bank of India has been involved in this decision. What is clear, however, is that there was no debate in the Indian parliament on this issue. Procedurally, if a “legal tender” is withdrawn, that should require – if not legally, at least ethically – parliament’s sanction.

Third, the suddenness of the decision had been a big surprise to all. A golden rule in policy-making is that radical decisions involve more risk. An alternative, and safer, approach would have been to withdraw these notes gradually with the help of the central bank. This approach would have avoided the short-run problems relating to a paucity of cash and reduced the transactional costs of the policy greatly.

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One possibility is that surprise was key to the policy’s potential success, as it gave the owners of black money no time to adjust. However, we argue that being rich, such people have the necessary money and manpower to react quickly. For example, newspapers are reporting that railway tickets are currently being booked in bulk with old notes of high denomination. To carry out this type of work on a large scale, one obviously needs money and manpower. Those who have both can follow a similar strategy of dividing big cash into many small chunks and converting them either to deposits or small denominations. Obviously, the policy of the Indian government will increase the cost and risk associated with such activities now and in this way may lead to a reduction in corruption. However, the above observations also suggest that dramatic changes are unlikely.

More importantly, our concern is that the very high transaction cost the policy has unleashed could itself lead to the creation of a (black) market for converting big notes into smaller ones. It could also lead to the hoarding of smaller denomination notes and cash in general. The possibility of hoarding implies that the demand for cash would exceed the normal transactional need and satisfying it will not be easy in the short-run. If the hoarding problem is not addressed quickly, then the current crisis may persist for a long time.

Finally, while our research suggests that the removal of large notes helps a country to reduce corruption, we do not suggest that cash as a whole should be removed totally. Cash transactions are anonymous, while all other transactions leave a trace. Today that trace may help us to reduce corruption, but the lack of anonymity in an economic transaction always helps the incumbent political power. We fear that dictators will love this power, as it will help them to anticipate any political move by the opposition.

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Bhattacharya, Kaushik and Sunny K Singh. 2016. "India’S Attack On Black Money - Policy Forum". Policy Forum.