Will demonetisation become de rigueur?

Steve Worthington

Steve Worthington Professor at Swinburne University

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The world is going cold on cash. Successive moves by global governments to consider or act on a reduction of banknotes in a bid to, among other things, clamp down on illicit purchases. Digital payment methods are of course the beneficiaries.

It’s not all straightforward however – in India’s case especially, there have been unforeseen consequences. There are lessons in the experience for others around the globe.

And, as an aside, even though we haven’t even dispensed with cash, the global payment schemes like MasterCard already talking about the end of cards – within a decade – as the technology behind them migrates to smart phones, watches and other wearables.

The Indian Government’s announcement in November 2016 it would demonetise its then-highest denomination bank notes, the 500 and 1,000 Rupee, was an attempt to simultaneously flush out from the black economy, the illegal proceeds of corruption and reduce the scale of tax evasion in India.

At the stroke of a pen 86 per cent of India’s bank notes were made invalid, in a country where well over 80 per cent of consumer transactions were made in cash.

It’s safe to say this was a big deal. India had 14 per cent of its GDP in circulating cash, compared with around 5 per cent in other large economies, so there were a lot of notes to be demonetised. The initiative can be interpreted as ‘encouraging’ Indians to begin the transition from a cash-centric economy to a more digital payments economy.

Other central banks who issue bank notes, while not yet willing to emulate the Indian Government’s radical experiment, are however concerned about the use of high denomination notes to facilitate illicit and illegal activities.

Outside India, the European Central Bank plans to abolish the issuance of the highest denomination note in the Eurozone, the Euro 500, by the end of 2018.

A July 2015 report from Europol, the law enforcement agency of the European Union, described the Euro 500 note as the criminal “instrument of choice” to facilitate money laundering and claimed criminals will pay a premium to acquire Euro 500 notes.

In mid-December 2016 the Australian Government, through the Minister for Revenue and Financial Services, announced the creation of a taskforce to “crack down on the ‘Black’ economy in Australia”.

The task force is reportedly considering measures such as removing the $A100 note from circulation and not permitting cash purchases above a certain amount, as already occurs in several European countries. The challenge in Australia – as the Reserve Bank has noted – is the black economy downunder is more reliant on the widely used $A50 bill for the very reason it is widely used legitimately.

Unforeseen consequences

The Indian demonetisation experiment has already had some unintended consequences which other currency jurisdictions need to be aware of before contemplating similar moves.

Firstly, the Indian Government was hoping for a ‘windfall’ from illicitly acquired bank notes not being deposited in bank accounts before the deadline.

However, by early January 2017 data from the Reserve Bank of India showed over 14 Trillion Rupees out of the 15.5 Trillion Rupee notes demonetised had been deposited, despite the stringent checks for untaxed income.

This amount was far more than the 10 Trillion Rupees the government initially predicted, which suggests people had found ways to circumvent the system.

One common way for those with bank notes worth more than the limit each individual could deposit, was to ask family, friends and where relevant employees to pay in cash they were given, which could then be transferred back to the individual later, minus a commission for the service rendered.

Secondly, in an economy growing at over 7 per cent, per annum, the lack of high denomination bank notes to pay suppliers and employees has caused significant damage to the Indian economy.

A survey of just under 10,000 SME’s recently conducted by the All Indian Manufacturers Association suggests a dramatic drop in business activity since demonetisation was announced in early November 2016. Jobs in the SME’s appear to have cut by a third and revenues are down by a half.

Larger companies may have been similarly affected, with a report in the Times of India that sales in the consumer durables sector fell by over 35 per cent in November 2016.

Thirdly, in an attempt to wean people away from using cash, the Indian Government made India the first nation to subsidise the use of digital payments when it unveiled a series of measures including discounts for rail tickets, road tolls and insurance policies when purchased online.

Service tax on online transactions below 2,000 Rupees in value will also be waived, as the government attempts to make Indian’s more comfortable about using digital payments.

The mobile payments market in India experienced a surge in transactions in the period post demonetisation and India’s leading mobile payments company Paytm reported a jump from 135 million digital wallets in use prior to demonetisation, to 177 million wallets by the end of December 2017.

Drama

So where will it end? Before demonetisation the Indian tax base was around 10 per cent of its economic output, a low figure when compared with other BRIC (Brazil Russia India China) economies.

It is estimated that only 5.5 per cent of employed Indians pay income tax, while nearly 85 per cent of the economy is outside the tax net.

There are suggestions other dramatic reforms are being considered in India, such as abolishing income tax and replacing it with an ad valorem banking transaction tax, say of 2 per cent, on every transaction that takes place through the financial system.

For such a measure to be even feasible requires the majority of transactions are conducted digitally, which allows them to be tracked and hence taxed more easily.

Such a behavioural change will certainly not happen overnight in India and the Indian Government issuance of new 2,000 Rupee notes, to replace the 500 and the 1,000, will hardly help to facilitate the curtailment of the ‘Black’ economy in India.

Those who wish to use cash to avoid paying tax will now have an even higher-denomination note to play with than before.

Steve Worthington is a Professor at Swinburne Business School

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