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The Modi government's demonetisation of high value currency notes has evoked a strong response from both sides of the aisle. The government and the supporters present it as a tool to eradicate unaccounted wealth, or black money, and to kick-out the cash economy and informal sector in favour of the formal sector. Those opposing the move tout the inconvenience it has caused to the common people and its negative impact on economic activities. Cash transactions accounts for nearly 90 per cent of economic activity in the country, which has now been crippled by the acute shortage of cash triggered by the policy.
The inconvenience of standing in queues to withdraw your own income and wealth is real and so is the potential loss in income and welfare that a liquidity squeeze induced economic downturn could bring in the coming months. Critics are however missing the biggest elephant in the room — the status of rupee as a storehouse of value or wealth.
A currency serves two distinct purposes: it is a medium of exchange to settle economic transactions and a store of value. The two functions may seem distinct but the first is critically depended on the recognition of the other. If people lose their confidence in the rupee as a store of value due to a fear of appropriation by the issuer, they would be reluctant to accept it in exchange for goods or service they offer.
The question may not look obvious given the current rush among people to take hold of the available legal cash in the system, but many people, especially high income earners and big savers, will start asking this question once liquidity in the system normalises in the coming months. For many savers this sudden and abrupt demonetisation of Rs 500 and Rs 1,000 notes is nothing short of wealth destruction if not outright appropriation by the government in the formal sense.
The actual act of appropriation is however not very far away. There is talk of the Reserve Bank of India (RBI) striking off currency not presented to banks for exchange by the due date from its balance sheet. If the central bank ends up doing that this would be nothing but appropriation of private wealth by the sovereign. However, there is no official confirmation of this from either the RBI or the government.
The currency in circulation is a liability for RBI, backed by assets such as government bonds, gold coins & bullion, coins in circulation and foreign currency assets such as dollar. The reasoning goes that the central bank will cancel the currency not presented to the banking system leading to a decline in its liability by a similar amount. This will increase RBI’s net worth by an equal amount that it can then transfer to the government as a one-time special dividend.
The government can use the bounty to reduce its fiscal deficit or spend it the way it chooses. According to various estimates the total gains for the government could be around Rs 3 lakh crore. For supporters this 'bounty' for the exchequer is the biggest reason why demonetisation should be supported at all costs.
There is no official line on this but if the government does follow the path what stops succeeding governments from repeating the act in the future. Given such a scenario, why would anyone save his or her surplus income in rupees. Isn’t the individual better off moving his or her assets to gold, bullion, real estate or dollar which cannot be demonetised by a government notification overnight. If this tension is not resolved it could potentially lead to a run on the rupee, which would be ruinous to the economy.
The government's argument that demonetisation only affects those with unaccounted wealth doesn’t hold water here. A currency system works not because it permits a certain kind of transactions (formal) but because it affords the flexibility or fungibility to settle any kind of economic transaction regardless of their legal character. Kill this flexibility and you kill the currency system itself.
