Demonetization: An argument for Bangladesh

Written By: S M Shafqat Shafiq & Zahrah Rahman

On November 8th, 2016, India’s Government announced the abrupt Demonetization of the 500 and 1000 Rupee notes. These notes accounted for 86% of the currency in circulation. Yet, 99% of these notes were eventually returned to banks. The hysteria created by this sudden midnight announcement took over both local and global media headlines. The question remains, was it a “good” decision? Did it meet the long-term policy objectives? Is it something that can be implemented in Bangladesh? In order to answer those questions, we first need to understand what Demonetization is, and why we believe, in the long run, such a move will benefit Bangladesh.

Demonetization is the process of rendering null currencies for the purposes of settling legal tenders. Countries usually implement Demonetization policies when they want to introduce a set of brand new currencies in the economy.

Bangladesh’s economy runs on cash. While a cash based economy can improve consumption metrics in the short-run, issues such as tax-evasion, fake currency circulation, inflation and corruption erode whatever benefits can be realized in the long-run. This has been the case for Bangladesh as well. GFI’s 2020 report stated that Capital Flight out of Bangladesh accumulated to about $5.9 Billion, while tax-evasion and corruption practices also ran rampant.

Inflation rate, as per the Bangladesh Bank, stood at a staggering 9.3% for the month of March, 2023. It was 6.22% the same time last year. Things do not look very promising on the Household Income and Expenditure side either. According to the latest HIES report, the average national household income stood at just TK 32,422 per month, while the national household expenditure stood at TK 31,500 per month. Of course, these statistics don’t take into account the unequal distribution of wealth within the populace (since the primary drivers of consumption and inflation in the economy are the high income earners), but what they do tell us is that the average National Household Saving is just around TK 1000 per-month. Again, since the distribution of wealth is not taken into account, one can infer from economic theory that the highest savers in the economy are also those who earn the most, while those lying in the middle and lower-income quartiles, ones who have the lowest disposable incomes, are saving the least. At a macro level, this means that most houses are having to dip into their savings to try and meet their expenses, resulting in a net decrease in National Savings.

Depreciating Exchange Rates, increased Import costs, and reduced Net Exports, have resulted in the rapid depletion of FOREX reserves. Additionally, Bangladesh Bank’s Monetary policy, which primarily relies on using the Money Supply to determine output and control for inflation, has been inefficient at best. Money Supply does indeed help control economic output, however, using Money Supply as the primary tool to implement Monetary Policy is highly inefficient.

With rampant inflation, fast depleting FOREX reserves, a tax-to-GDP ratio of only 8.5%, large volume of black-money in circulation and an underground economy that is estimated to be around 60-70% of GDP (Haque, 2013), Demonetization is perhaps the most robust policy that can be implemented to effectively tackle some, if not most of these issues.

Demonetization would not only help take fake money out of circulation, but it’d also force individuals to submit their tax returns and declare their incomes, thereby increasing Government receipts through tax, and formalizing a large chunk of the informal money market. Additionally, Demonetization would also have positive effects on both savings and inflation rates. For one, it is likely to encourage people to start depositing more of their money into bank accounts instead of holding cash, resulting in an overall increase in the National Savings Rate, thereby making it cheaper to borrow. It would also reduce consumption, consequently bringing inflation rates down to a more acceptable bandwidth.

Despite all the advantages, however, Demonetization also brings with it certain drawbacks. Firstly, since Demonetization tends to decrease the money supply in an economy, people will have less money to spend. Both spending and consumption will therefore decrease and while that may bring inflation down in the long run, the short run effects will see increased unemployment rates and decreased output.

Next, while a sudden Demonetization may produce a certain degree of control over the volume of black money that’s circulating in the economy, it is likely to also generate panic and uncertainty among people.

Finally, it is valid to suggest that Demonetization in India did not produce the expected results. As 86% of India’s currency disappeared overnight, it was expected that a significant portion of black money would be eliminated from the flow as well. However in its annual report, the RBI stated that only 10,720 crore rupees did not reach the bank, which amounted to just 0.7% of the demonetized notes.

Despite the underwhelming effects, however, Demonetization did have a net positive effect on the Indian economy. To begin with, Demonetization boosted India’s National Savings Rate, allowing for targeted investments to occur. This not only steered India through the Pandemic-induced recession, but also ensured her lowered reliance on Foreign Direct Investment.

In addition, Demonetization also galvanised the digitization process of India’s payments system. It is quite rare nowadays for Indians to make mention of ATM booths or cash transactions.
Finally, while a sum of 10,720 crores may seem meager, it is still a significant amount. Therefore while the effects of Demonetization were not immediate, the lagged effects are conspicuous and suggest nothing but realization of long-term benefits.
For Bangladesh however, Demonetization could be aimed at increasing the economy’s rate of digitisation. Digitization of the payments system will assign more transparency to wealth accumulation and retention of both individuals and entities that operate in the economy.
With digital transaction platforms such as BKash and Nagad reporting record volumes of digital transactions made in 2022-2023, along with unprecedented mobile and internet penetration throughout the country, the appetite for digitization is already there; Demonetization will perhaps provide the much needed “nudge” to make this important shift.

As a consequence, the tax burden, which currently overwhelmingly relies on regressive tax policies such as consumption tax, can be shifted to the more progressive, and equitable policies such as income tax. Additionally, digitization of the currency will offset any risk of counterfeit and fake notes being circulated, resulting in a stronger and more resilient financial system.
Demonetization will also aid in reducing the inflationary pressures that currently plague the country. “Denomination Effect”- a psychological phenomenon that posits that people are less likely to spend larger denominations of a currency – suggests that the optimal effects of Demonetization can be achieved by getting rid of lower denominations. Exercising such a Demonetization policy is bound to manifest positive albeit lagged effects for Bangladesh’s macroeconomy.

In conclusion, we restate our hypothesis that Demonetization will generate positive changes to Bangladesh’s economy. Many of the predicaments that currently hinder the macroeconomic performance of the country, can to a certain degree, be offset by this policy. While its effects may not be immediate, Demonetization, if executed within the purview of an evidence-based framework, will realise excellent long-run benefits for Bangladesh’s economy.

S M Shafqat Shafiq is YPF’s Fellow for Big Data and Poverty. A Mathematical Statistician and Theoretical Econometrician by profession, he’s also a product of the University of Sydney.
Zahrah Rahman is the lead of YPF Economics Policy Team and a recent economics graduate from BRAC University.


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The Great Indian Demonetization

Featured Image Courtesy: ET Now News


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