At any given point in time the RBI knows how much currency is in circulation because it printed the currency in the first place. If the RBI withdraws that currency, then whether or not people return the notes to the bank, the RBI can print the same amount of money. The govt / RBI don’t need you to deposit the money into the bank; whether or not you deposit, the money is already renewed.
This action is being advertised as a patriotic act of fighting against corruption and black money. The truth underlying it is quite different. The driver for this act is the huge number of bank loan defaults that have occurred. Remember the US economic crisis of 2007 where the borrowers could not return the loans? India is in a similar situation with one big difference: the defaults are largely by the rich and powerful.
Since most banks are nationalized, the govt can pursue their recovery. Which private bank has billions in default, a handful of big borrowers, and doing nothing about it? Yes, Indian nationalized banks are like that. They lend billions to big industrialists, which don’t return the money, and the bank is guaranteed by the govt.
When the bank runs out of money, then it increases interest rates. The result of that is everyone has a hard time finding money — ultimately this slows the economy.
To restart economy, govt typically prints more money — print paper currency to give out low interest loans. However, since the newly minted currency isn’t backed by a corresponding economic growth, there is more money for the same amount of assets, and hence the value of money relative to the assets decreases. This is called inflation.
Indian govt also wants to print money to start growth, so that it can give out low interest loans again. Guess who will get most of those loans? You guessed it right: the big borrowers you have already defaulted. However, to avoid the consequences of simply printing NEW money (inflation) Indian govt is cancelling old money and printing new notes as a replacement for the old money. In economic terms, this should not cause any economic inflation, because the total money remains the same, and the assets backing the money are also the same. Net-net, no change.
Except for one big problem: the people who defaulted on the previous loans have already converted that money into assets, parked it abroad, or invested in something that they are not going to tell you, unless you investigate them and put them behind bars. The really big borrowers are not keeping the money under their bed. They have already moved the money into different things long back. The money is already distributed to an extent that you can’t trace it back to the borrower. So, when you cancel the currency, the govt gets the money back, and the defaulter gets to keep the money he/she borrowed. In short you ate your cake and you have it too!
There will be few people who have kept the money under their beds, and they haven’t eaten their cakes, and now they don’t have the cake. But the biggest chunk of this money is not like that. The biggest chunk is the big borrowers from banks you have defaulted on loans. The govt banks don’t care because they got the money back. The rich defaulters don’t care because they never had to return it.
So, what really happens when the lender (govt banks) gets its money back, and the defaulter never returns it? It is the poor guys who were borrowing and paying interest diligently who bear the brunt. The money that the govt banks have on default today is 6,00,000 crores. This is the amount that will be recovered from the common man/woman — either through higher interest rates or through price rise.
We must note that RBI under Raghuram Rajan was not prepared to lower the interest rates. It was focused on retrieving the money from the defaulters before lowering the interest rates. GOI is pursuing the opposite agenda where you cancel the money, which allows you to print the money, WITHOUT going after the defaulters. If the defaulters have to pay, then the govt has done its job, and the common man/woman is not impacted. If the defaulters don’t pay, and the govt just cancels the currency, the loans that have defaulted have to be recovered somehow.
We have two kinds of alternatives now. First, we can treat the bad loans as “lost money” and the new currency is now considered devalued — i.e. rise in inflation. Second, we can treat the bad loans by the defaulter as the price to be paid by the common borrower through a higher interest rate over a period of time.
In either case, the common person loses due to the defaulting borrower. Either they pay more money for the same goods they were previously buying cheaper. Or, they pay higher interest rates for the money they were borrowing. If the interest rates don’t come down, then the whole point of demonetization will be moot, because banks will suddenly have lot of money but nobody is borrowing that money due to high interest rates. Since this is clearly undesirable, the banks will be asked to reduce interest rates. That leaves you with the next best alternative — i.e. inflation in prices.
Demonetization now becomes equivalent to printing more money out of thin air, because someone defaulted on the loans. The defaulter never returned the money, the govt printed the money, so effectively, the value of money is now reduced.
We may recall a similar situation in the US banks in 2007 when a lot of homeowners defaulted on their loans. The solution to that problem was govt driven bailout. The homeowners lost their homes, the banks got all the money from the govt (so they were largely not impacted) and the taxpayer bore the brunt of bad loan. The net result of that was a greater debt in the US govt, a greater budget deficit, and rising interest rates, all of which means that common people were worse off. They can’t borrow money to start a business, the govt therefore cannot collect taxes — and hence both govt and the common man are worse off — but the banks are laughing because they got all the bad loans from the govt, and the govt cannot get it back from the people.
The risk of the loan must ideally be passed to the borrower. In the case of US economic crisis of 2007, the risk of bad loans was passed to hapless investors who new knew nothing about the risks in the loan, and to the govt which bailed them out. Ultimately, small investors lost because their investment was gone; the homeowners lost because they lost their home; all tax payers had to pay more taxes OR suffer from price rise (inflation). The banks did not lose. In the case of India too, the risk of defaulted loans will also be passed to the common man. It so turns out that in the case of US, the borrowers were common people, and in the case of India the borrowers are super rich. In the case of US, the rich got their money back from the govt, and in the case of India, the rich get to keep the money they borrowed.
Who do you think is winning, and who is paying the price of that win?
The unfortunate part of this exercise is that it is being politicized as an action against black money by a patriotic govt, when real patriotism here means going after the loan defaulters, taking away their property, and forcing them to pay. But, of course, that won’t happen because the rich fund the political campaigns. The only difference between US economic crisis of 2007 and Demonetization in India in 2016 is that the role of banks has been taken over by the super rich borrowers. The similarity is that in both cases the rich kept the money, while the poor will pay the price for it.
Specifically, in the case of India, the defaulted loans will be recovered from the common man/woman who will be working harder to repay the rich guys defaulted loans. Since we are patriotic, we can do that for the nation .. can’t we?