Ripple effectSince the Nepali rupee is pegged to the Indian rupee, the note ban could affect Nepal
When a currency unit is demonetised, it stops being legal tender. The policy causes immense restriction and discomfort to the economy and people. On November 8, Indian Prime Minister Modi announced that 500- and 1,000-rupee notes were being pulled out of circulation. People were given 50 days to deposit them in their bank accounts or exchange them for new notes at banks and post offices. The main objective, the government said, was to eradicate black money, combat corruption, counter tax evasion and destroy counterfeit bills. India has demonetised its banknotes twice in the past, in 1946 and 1978. But there was little disruption then as the scale of the economy was small unlike today.
Banknotes of 500- and 1,000-rupee denominations make up 86 percent of the cash in circulation in India. Most transactions are cash-based and only half of the Indian population has bank accounts. The formal and informal economies are not isolated from one another but form a seamless value chain. The informal economy accounts for 45 percent of the GDP and 80 percent of the workforce.
The good and the bad
Against this backdrop, the government’s demonetisation move has a tremendous impact on the Indian economy. A lot of cash-based consumer transactions have ground to a halt. Sales of consumer goods have plunged one-third. The ATM network has been hit by total chaos while the central bank struggles to print replacement currency. The construction industry has suffered with significant wage implications for its workforce. People are scrambling to pay for goods and services, which means the cash shortage will likely take a big toll on the country’s growth and output. Consumption makes up for around 59 percent of India’s GDP, hence, a drop in spending will pull down growth.
The good news is that demonetisation has eliminated fake money in circulation, black money has been entered in the account books or destroyed, the GDP has received a boost with IRs12.44 trillion being deposited as of December 13 according to the Reserve Bank of India (RBI) and economic activity has speeded up due to a drop in lending rates. Moreover, all that money entering the economy will help to reduce the fiscal deficit. Advances in technology have allowed economic transactions to be conducted digitally, paving the way towards a paperless economy. The move is likely to lead to better tax compliance, raise the tax-to-GDP ratio and improve tax collection, leading to lower borrowing and better fiscal management.
Nepal has a peculiar relationship with India. The Nepali rupee is pegged to the India rupee, and even a slight movement in the Indian economy affects Nepal’s economy. An open border, large-scale business partnering and informal transactions in the border areas are some of the major factors causing a direct impact on the Nepali economy. Also, millions of Nepalis working in India play a vital role in the economy. Informal transactions between Nepal and India have been greatly impacted resulting in fewer transactions. Millions of Indian rupees in cash earned by Nepali workers in India may be stored in rural areas, especially in the far western parts of Nepal.
If India’s economic growth rate drops, there will be an impact on Nepal’s economy too as a lot of migrant workers employed in India might lose their jobs and their earnings might shrink. There will be an impact on the banking sector too, though not directly, as many Indian businesspersons operating in Nepal who have borrowed from banks may delay repayment or default on their loans. Further, there are a lot Nepali students pursuing studies in India, and many Nepalis go to India for medical treatment and religious purposes. Nepal Rastra Bank (NRB) buys Rs6 billion worth of Indian currency notes by selling US dollars to be able to provide cash to Nepalis travelling to India for education and pilgrimage.
Lessons for Nepal
Will the world’s fastest growing big economy show resilience and regeneration from deep shock therapy or will demonetisation cure the disease? It’s a time to wait and see. Positive sentiments injected by government-led by tax cuts could be one of the initiatives. If demonetisation is considered to be a short-term pain and long-term gain for the economy, it will definitely meet the objective.
For Nepalis, this is the time to learn a few lessons. Priority should be given to our own currency. Informal transactions in the border areas should be reduced and passed through banking channels. Cash transactions need to be curtailed, and the country should move towards a paperless digital solution. A self-reliant economy should be developed. As for a short-term solution, it’s time for NRB to liaise with the RBI for the exchange of IRs500 and IRs1,000 currency notes lying in the pockets of the Nepali people. If needed, coordination should be conducted at the government-level as the Bhutanese government has done.
Pokharel and Bhandari are chartered accountants