In a so-called master stroke by PM Modi, the Rs. 500 and Rs.1000 denominations will now be out of circulation for the Indian economy. Let us look at the various nitty-gritty of this policy decision.

No more a legal tender

  • A legal tender is any acceptable currency in a country. The denominations are declared by the government.
  • In India, different values of the Indian rupees are legal tender. The Reserve Bank of India (RBI) Act and the Indian Coinage Act specify which bank notes and coins will be legal tenders.
  • The Central government under Section 26(2) of the RBI Act has the authority to declare currency as not valid legal tender. This is generally done on the advice of the central board of directors of the RBI.
  • Section 24 of the RBI Act empowers the Central government to issue bank notes of any value, as long as it is Rs.10,000 or below. Hence, there is no amendment in law required for any changes in legal tender.
  • Recently, the Central government has declared that Rs.500 and Rs.1,000 will not be accepted as currency notes, thus these two denominations are no longer legal tender. Hence, these notes have no value.
  • It means that people cannot use existing Rs. 500 and Rs. 1,000 currency notes for monetary exchanges.
  • Also, the central government is set to introduce two new currency notes of value Rs.500 and Rs. 2,000.

Continued efforts to harm parallel economy

  • The decision comes in the backdrop of curbing the challenge posed by corruption and black money.

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Picture credit: http://www.livemint.com/r/LiveMint/Period2/2016/11/09/Photos/Processed/w_black_money.jpg

  • And now, the five hundred rupee and thousand rupee currency notes presently in use will no longer be legal tender.
  • However, there is no restriction of any kind on non-cash payments by cheques, demand drafts, debit or credit cards and electronic fund transfer.

Reason behind such decision

  • The honest citizens want that government fights against corruption, black money, Benami property, terrorism and counterfeiting.
  • The magnitude of cash in circulation is directly linked to the level of corruption.
    • Between 2011 and 2016, the circulation of all currency notes, from the lowest to the highest denomination, grew about 40%.
    • In the same period, the circulation of Rs 500 denomination and Rs 1000 denomination currency notes increased by 76% and 109% respectively.
    • But, the size of Indian economy during this period expanded by only 30%.
    • So obviously there has been a disproportionately high usage of high denomination currency notes
  • Inflation becomes worse through the deployment of cash earned in corrupt ways. It has a direct effect on the purchasing power of the poor and the middle class.
  • In the purchase of land or a house, apart from the cheque, a large amount of cash is demanded.
  • Thus, misuse of cash has led to an artificial increase in the cost of goods and services like houses, land, higher education, healthcare and so on.

Effects of the move

  • As per RBI’s latest annual report, Rs. 500 and Rs.1000 denominations account for over 86% of the total Rs 16.42 lakh crore value of bank notes in circulation as on March 31, 2016.
  • Incidentally, the decision comes close on the heels of the expiry of the September 30 deadline of the black money disclosure scheme under which income and assets worth Rs 65,250 crore were declared.
  • With almost 60% of the economy estimated to be a cash economy, the decision is likely to be quite disruptive in the short-term.
  • India is a cash-based economy, hence the circulation of fake rupees continues to be a menace. The fake notes are used for anti-national and illegal activities. Thus, it is now expected to contain the rising incidence of fake notes and black money.
  • The decision is also expected to severely impact sectors that deal with unaccounted money such as real estate, the stock market and gems and jewellery.
  • However, it will also hit the livelihood and savings of neighbourhood vegetable vendors who borrow overnight funds from moneylenders, Kirana stores, small traders and even the labour class.
  • There will be temporary glitches occurring due to the transient nature of replacing the currency but the RBI is already ready with new currency notes of Rs. 500 and Rs. 2000 to meet the requirements in upcoming weeks and days.
  • In addition, the government has made clear that the now defunct two denominations in bank accounts will not enjoy immunity from tax and the law of the land will apply to the source of such money.

Effect on real estate

  • The sector is known to be a safe haven for converting stock of black money into white, especially in high-value transactions. High-value property deals and more specifically resale transactions involve large amounts of undisclosed cash transactions.
  • Thus, there is expected to be a slowdown in transactions, which will further affect the performance of real estate companies.
  • However, lower interest rates have brought some hope for the sector. A slightly better outcome is if prices decline which sees a revival in demand from buyers who don’t conceal their income from the tax authorities.

Effect on markets

  • The Sensex is made up of very large companies which may not be impacted as much by the demonetization process.
  • The largest impact of the government’s move will be in the unorganised sector, which isn’t represented in the markets.

Effect on voter base

  • The decision may affect the current ruling majority party’s key support base—traders, small and middle-level businessmen. However, many feel that traditional party supporters like lower/middle class will not find it tough to account for or exchange the currency. The real fear will be for those who have unaccounted money.
  • As per analysts, with assembly elections due in five states over the next six months (Uttar Pradesh, Punjab, Uttarakhand, Goa and Manipur all go to polls), the move is risky and brave.
  • Elections attract cash, and the move means “campaigning is going to be a big headache for political parties”

Thus, this move is expected to bring more transactions under the tax net, both direct and indirect taxes would move up, more digital transactions will take place and reduction in the parallel economy will increase the size of the formal economy as more people will disclose income and pay taxes. This will make India a more tax-complaint society.