Demonetize huge amount onetime vs Demonetise smaller amounts frequently..

JP Koning’s blog keeps coming out with posts related to India’s demonetisation. Most people say demonetisation is over and not worth the time now. Well for  scholarship on monetary economics, India’s demonetisation deserves to be as widely researched a subject as any for many years. It just has so many facets to it.

In his recent post, Koning says instead of massive demonetisation drive onetime one could have smaller drives periodically. Interestingly in Philipines, Central Bank keeps withdrawing currency fairly regularly as well. Its central bank act says:

SECTION 56. Replacement of Currency Unfit for Circulation. — The Bangko Sentral shall withdraw from circulation and shall demonetize all notes and coins which for any reason whatsoever are unfit for circulation and shall replace them by adequate notes and coins: Provided, however, That the Bangko Sentral shall not replace notes and coins the identification of which is impossible, coins which show signs of filing, clipping or perforation, and notes which have lost more than two-fifths (2/5) of their surface or all of the signatures inscribed thereon. Notes and coins in such mutilated conditions shall be withdrawn from circulation and demonetized without compensation to the bearer.

SECTION 57. Retirement of Old Notes and Coins. — The Bangko Sentral may call in for replacement notes of any series or denomination which are more than five (5) years old and coins which are more than (10) years old.

Notes and coins called in for replacement in accordance with this provision shall remain legal tender for a period of one (1) year from the date of call. After this period, they shall cease to be legal tender but during the following year, or for such longer period as the Monetary Board may determine, they may be exchanged at par and without charge in the Bangko Sentral and by agents duly authorized by the Bangko Sentral for this purpose. After the expiration of this latter period, the notes and coins which have not been exchanged shall cease to be a liability of the Bangko Sentral and shall be demonetized. The Bangko Sentral shall also demonetize all notes and coins which have been called in and replaced.

But this is more about retiring old notes to keep counterfeiting etc at bay.

Koning says one way to achieve this regularly is by declaring notes having a particular serial number as losing legal tender status:

This continues a series of posts (1, 2, 3) I’ve been writing that tries to improve on Indian PM Narendra Modi’s clumsy demonetization, or what I prefer to call a policy of surprise note swaps.

The main goal of Modi’s demonetization (i.e. note swapping) is to attack holdings of so-called “black money,” or unaccounted cash. The problem here is that to have a genuine long-run effect on the behavior of illicit cash users, a policy of demonetization needs to be more than a one-off game. It needs to be a repeatable one. A credible threat of a repeat swap a few months down the road ensures that stocks of licit money don’t get rebuilt after the most recent swap. If that threat isn’t credible, then people will simply go back to old patterns of cash usage.

…..

Weeding out rupee banknotes according to serial number rather than denomination would have allowed for a more refined policy along the lines advocated by Henry. Here’s how it would work. The government begins by declaring that all ₹1000 notes ending with the number 9 are henceforth illegal. Each person is granted a degree of protection from the note ban. Anyone owning an offending note can bring it to a bank to be swapped for a legitimate ₹1000 note (one that doesn’t end in 9). However, the government sets a limit on the number of demonetized notes that can be exchanged directly for legitimate notes, say no more than three. Anything above that can only be exchanged in person at a bank teller for deposits, which requires that they have an account (i.e. their anonymity will be lifted). Once an individual has deposited five notes in their account, all subsequent deposits of demonetized notes would require a good explanation for the notes’ provenance. Should the requisite paper trail be missing, the depositor gives up the entire amount.

The process begins anew a few months hence, the specific timing and banknote target being randomly chosen. So maybe thirteen months after the first swap, the government demonetizes all ₹500 notes ending in 6. Randomness prevents people from anticipating the move and hiding their illicit wealth in a different high denomination note. 

Too understand how this affects black money owners, consider someone who owns a large quantity of illicit ₹1000 banknotes, say ₹70 million (US$1 million, or 70,000 banknotes). This person faces the threat of losing 10% to the note swap. After all, when the 9s are called, odds are that he or she will have around 7,000 of them, of which only eight can be returned without requiring a paper trail. The owner can simply accept a continuing string of 10% losses each year as a cost of doing business.

Alternatively, they might protect themselves by converting their hoard into a competing store of value, say gold, bitcoin or low denomination rupee notes like ₹100s (which are not subject to the policy of ongoing swaps). If they flee high denomination notes, illicit cash users in a worse position than before the adoption of the policy of note swapping. Gold and small denomination notes have far higher storage and handling costs than ₹1000 banknote. And unlike gold and bitcoin, a banknote is both supremely liquid and stable.  

As for licit users of high denomination notes, the fact that the 10% clawback would not apply to them means they needn’t change their behavior. Nor would the poor, who are unlikely to be able to provide a paper trail, have to worry about the policy. Demonetizations would only occur in high denominations, in India’s case ₹500 and 1000s. The poor are less likely to own these in quantities above the three note limit.

Incidentally, readers may recognize a policy of repeat demonetizations as akin to a Gesell stamp tax, named after Silvio Gesell, who in 1916 proposed the idea of taxing currency holdings in order to increase the velocity of circulation. Greg Mankiw famously updated Gesell’s idea during the 2008 credit crisis to remove the zero lower bound. He did so by using serial numbers as the device for imposing a negative return rather than stamps. This post updates Mankiw’s idea, except rather than applying the tax to all cash it strikes only at illicit cash holdings, and does so in the name of an entirely different policy goal—attacking the underground economy, not removal of the zero lower bound.

A series of small serial number-based swaps seems like a better policy than Modi’s ham-handed demonetization of all ₹1000 and ₹500s. It would certainly do a better job of promoting a long-term decline in undocumented cash holdings and would do so by imposing a much smaller blast radius on the Indian public. There would be no currency shortages, huge lineups at banks, empty ATMs, or trades going unconsummated due to lack of paper money.

Not sure about this at all. Such measures always read like nice experiments but one has to see the overall context. India has massive amount of illiteracy and keeping people off guard regularly will create regular havocs. It is also important to note that Rs 500 and Rs 1000 notes are hardly high value given how inflation has eroded purchasing power over the years. Rs 500 atleast is used fairly common amidst even lower income people. So, it is not right to assume that poor will not be effected by repeated smaller demonetisation. Whether one time or regular, they are the ones who shall be hit given current denominations. Only if denominations are higher, can we even think of this measure.

Another problem shall be speculation against which number shall be demonetised next. Given how things work, markets are fairly good at guessing all this and we could see people refusing to accept notes even before the new demonetisation order. We have seen how Re 10 coin is not accepted despite being legal tender.

Any measures to manipulate currency usually backfire. People are way too smart than Governments think..

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