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Lately a debate on demonetization is taking place. There is no sign of taking or not taking any step from the government at this point of time. The passionate tweets and TV shows of ex-FBR chairman Shabbar Zaidi is bringing the issue into the foray. Here this piece tries to give a perspective to the discussion based on Pakistan’s history, learnings from India and general pros and cons of demonetization.

The debate started with a proposal by Zaidi on the discontinuation of Rs5,000 bill. Indeed, it’s a big note bill relative to the size and purchasing power parity of the country. Indeed, Rs5,000 bill, prize bonds and foreign currency (mainly $100 bill) are used for corruption (such as bribes) and black economic transactions (including domestic trade and real estate).

The currency in circulation (cash in hand) has always been high in Pakistan and the ratio has grown further in the past five years (since the introduction of tax on banking transaction and distinction between the filers and non-filers in terms of tax rates). Against a perception of a few, there was no increase in currency in circulation (CIC) after the introduction of Rs5,000 bill in 2006.

The ratio of CIC to M2 (broad money) on average was 23 percent (FY01-FY06) six years prior to introduction of Rs5,000 and the ratio was 22 percent (FY07-12) six years after it. In fact, the ratio fell after the Rs5,000 note was introduced in May 2006. The ratio was 23 percent in June 2015. In July 2016, the banking transaction tax was imposed and the government efforts to discriminate between filers and non-filers in terms of taxation were expedited. The ratio increased to 26 percent by June 2016. This means markets reacted to the government efforts and transactions sped up in the informal sector. The ratio started inching up since then and reached 28 percent by June 2019. Then Shabbar came and new efforts to curb undocumentation were introduced – the ratio increased to 29 percent by June 2020 – some role has been played by COVID in this – visible from Indian data too.

One can safely say that the efforts towards documentation (in the form of sticks) is not clearly working in Pakistan. Some fear that another stick could be counterproductive. They argue that it’s better for government to come with carrots (in terms of lowering the tax rates and incentives associated with digital transactions).

Before delving into these, let’s evaluate the impact of demonetization in India. On 8th November 2016, India abruptly (without taking banking system and public into confidence) demonetized ₹500 and ₹1,000 bills. The CIC to broad money ratio was 14 percent in FY16. Right after the demonetization, the ratio fell to 9 percent in FY17. Great. But, the decline was temporary. The ratio was back to 13 percent in FY18 and today it is standing at 15 percent.

Thus, there is no effect of demonization on the currency in circulation- apart from a short-term blip. Interestingly, Unified Payments Interface (UPI) was introduced in India in April 2016. Some say that demonization was to push start UPI i.e. digital payment system in India.

The UPI numbers didn’t grow due to demonetization. It became a success after WhatsApp Pay came in India in February 2018. Indian payments systems witnessed a sea change thereafter. But interestingly, it did no damage to higher currency in circulation. According to a study of Reserve Bank of India (RBI) “An increase in digital payments to GDP ratio over a period of time does not seem to automatically imply a fall in the currency to GDP ratio of the country”.

The point of connecting demonetization to UPI is that Pakistan has recently introduced Raast (equivalent to Indian UPI), and some may be thinking of a demonetization push to kick start Raast by saying that this will reduce cash holdings. The message is: don’t do it – this didn’t work in India.

Coming back to the debate of ending Rs5,000 bill. Well, this may not help in reducing currency in circulation; but surely this would make bribes and cash transactions difficult. But by doing so, the demand for foreign currency would grow. This could have adverse implications on currency parity. Though, it’s not easy to buy foreign currency now—so Shabbar’s argument may have some strength.

The government needs to take other actions to lower cash transactions. For example, real estate transactions of tens of millions rupees take place from lockers to lockers. Government should ban the cash holdings in bank lockers. Technology can be used to assure this without physically checking lockers. Another option is to ban note counting machine outside banks use.

The demonization could slow down the economy. That had happened in India and a country which was at high growth trajectory could have afforded it - but Pakistan growing at snail pace cannot. The foreign exchange reserves in India are much higher and dollarization wasn’t a fear there. But it is surely here in Pakistan. There is data on how much currency (Rs5,000 bills), prize bonds and all are issued. But we don’t have data on how much foreign currency is circulating.

Having said that, steps are required to lower cash in hand. Shabbar’s proposal is different from what India did. In India it was done abruptly. In Pakistan, a debate is going on which is the healthier route. In India, only declared money holders were allowed to deposit ₹500 and ₹1,000 notes. In Pakistan, there was no such bar for prize bond submission. In India, the conversion was allowed for short time. In Pakistan, prize bonds conversion had much higher time frame to do.

Thus, based on how things are moving in prize bonds, conversion of Rs5,000 bills to smaller bill (say Rs2,000) might work if it is well thought out. But don’t be fooled by believing that this will solve the puzzle of documentation. Not even Raast can do it alone.

These steps need to be supplemented by carrots. Such as lowering income and GST rates, especially for digital transactions. Crackdown on informal payment domestic shops and informal exchange companies. One big improvement can be made by curbing smuggling and under-invoicing of imports. The imports are processed from sea ports, airports and borders (for land routes). The need is take these away from the hands of FBR and automation of system can do wonders.

The bottom line is ending Rs5,000 note would neither kill the economy nor solve all the woes. The need is to work on other factors to incentivize documentation by using combination of carrots and sticks.

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