In an unprecedented announcement by Prime Minister Narendra Modi, in a live televised address to the nation at 8:15 p.m. IST on November 9. 2016, the Indian government declared circulation of all H500 and H1,000 banknotes of the Mahatma Gandhi Series as invalid. The prime minister also announced the issuance of new H500 and H2,000 banknotes of the Mahatma Gandhi New Series in exchange for the old banknotes.

The decision to demonetize H500 and H1,000 banknotes came as a surprise, and is part of a series of Indian government interventions to crackdown on tax evasion, counterfeiting and funding for terrorism.

The H500 and H1,000 banknote denominations account for 86% of all banknotes in circulation1 and account for nearly 12% of India's GDP. The Economic Affairs Secretary, Shaktikanta Das, alluded to the unexplained rapid rate at which these notes have grown in circulation in the last five years H500 notes by 76% and H1,000 notes by 109% to justify the rationale for the demonetization.

The following are probable consequences of demonetization of H500 and H1,000 banknotes on the Indian economy:

1.Temporary effect on money supply

With the older H500 and H1,000 banknotes being invalid legal tender, until the new H500 and H1000 banknotes are widely circulated, money supply is expected to reduce in the short run. However, as the new notes get circulated, money supply will gradually increase.

2.Increase in deposits and savings, leading to lower cost of capital

As a significant proportion of the older H500 and H1,000 banknotes are expected to be deposited with banks, it is possible there will be an increase in banking deposit base. In turn, financial savings are expected to rise due to the switch from savings from unproductive physical assets to financial assets. This will enhance the liquidity position of the banks, which will utilize the funds for lending purposes. A rise in deposit base might also allow banks to lower the blended cost of funds as higher CASA (current accounts, savings accounts) deposits help to replace the high cost of borrowing and lower overall cost of funds.

3.Support for government finances

With some part of unaccounted money making its way into the formal channel, the government stands to benefit from higher income tax collections. This should help cushion the government's FY17 fiscal deficit target. The announcement will move the economy from the unorganized to organized sector, dovetailing into the GST architecture that is expected to come on board next year. It is also likely to enhance the government's ability to tax commercial transactions, resulting in a structural improvement in tax-to-GDP ratio in the economy.

4.Effect on cash-dependent sectors

The below mentioned sectors are expected to have moderation in demand in the near term from the consumer side, and a possible reduction in price levels, owing to the significant amount of cash transactions involved in these sectors:

  • Consumer goods
  • Real estate and property
  • Gold and luxury goods
  • Automobiles

5.Cashless transactions

With cash transactions facing a reduction, alternative forms of payment will see a surge in demand, such as e-wallets and apps, online transactions using e-banking, and debit and credit card usage. This should eventually lead to strengthening of such systems and the infrastructure for cashless transactions.

6.GDP growth potential

India's informal sector could be significantly impacted by the demonetization, especially in rural India, and it is possible that this will reduce GDP growth in the near term. There are also short-term implications for growth in cash-intensive sectors and discretionary household consumption. However, most economists expect the long-term benefits of demonetization on GDP growth to outweigh these short-term transitional impacts of demonetization.