As part of his government’s fight against corruption and terror financing, Indian Prime Minister Narendra Modi shocked the nation on November 8 by announcing that the Reserve Bank of India (RBI) was going to demonetise Rs500 and Rs1,000 Indian currency (IC) notes. Given that there is a high circulation of IC in Nepal, the Indian government’s move has naturally raised concerns in the country. Nepal Rastra Bank (NRB) has stated there are around 33.6 million Indian currency notes of Rs500 and Rs1000 denominations in the banking system, but the actual amount of IC in the country is unknown. Mukul Humagain and Rupak D Sharma spoke to former finance secretary Rameshore Khanal about the scrapping of 500 and 1,000 IC notes, its implications for Nepal’s economy and trade, and the effectiveness of the move in controlling corruption and terror financing.

How will the demonetisation of Rs500 and 1000 currency notes by the Modi government in India impact the Nepali economy?

This is not the first time high-denomination rupee notes have been withdrawn in India. The Indian government resorted to this measure thrice in the past—in 1946, in 1957 and in 1978. They did not have any adverse effect on the Nepali economy. This time around, however, some repercussions might be felt here, but not in a large scale. The people in the bordering areas might get affected the most, as many transactions involving Indian currencies take place there due to the open border. But although many people might get affected, the amount of cash lost will not be significant. Similarly, even Nepali banks have Indian currency holdings, and if they do not get to change their money, they will face losses. But even the banks do not have large holdings of Indian currency.

Instead this decision benefits Nepal in controlling black money inside its own territory as many people in the country are illegally holding Indian currencies and using them for illegal activities, which now they might have to lose.

Do you think the Indian government’s decision was right? How does it work to our benefit?

The rationales behind the decision to scrap notes in 1978 and those of the present Modi government are similar to a certain extent. In 1978 the government decided to demonetise currencies to curb corruption and particularly to control gangsters. Similarly, the present Indian government also wants to control corruption and the black economy. It seems the focus this time around seems to be on deterring terrorist activities. This decision of the Indian government must be respected, as a country sometimes needs to adopt harsh measures to buttress its economy. Withdrawal of high-denomination rupee notes is a radical measure a government takes to control corruption, counter forgery and take back unaccounted cash, popularly known as black money, from the economy. And the recent move may help achieve these goals, but only time will show the real impact. 

The move will have similar effects on the people involved in illegal activities using Indian currency inside Nepali territory. The ones with huge holdings will suffer immense losses. This will deter existing and potential perpetrators from getting involved in illegal activities.

An additional problem with illegal activities, which give birth to the underground economy—economic activities outside formal banking channels that are unrecorded and untaxed by the government—is that they increase the money supply in the economy. This directly results in inflation in the formal economy. So getting this unrecorded surplus cash out of circulation has a cooling effect on market prices. Let us take the example of India only. According to the RBI, there was 260 billion in circulation until October end. But we do not know for sure how much of it is illegal cash. Even if it is only 10 percent, a huge amount which if removed from the economy, will have an impact on market prices. Given that the Nepali currency is pegged to the Indian currency, and that 60 percent of our inflation is directly related to the Indian economy, a price drop in India will benefit us as well.

How will it affect our cross-border trade, which is mostly informal and transacted in Indian currency?

It will affect all our transactions in Indian currency and this is another advantage. If the Indian economy and its trade are made more transparent, it will automatically reflect on our trade with them. The aim of the Indian government is to deter illegal activities by regulating its money, and if it successful, it will automatically reduce illegal activities within Nepal too.

Illegal practices while conducting formal cross-border trade, like payment under the table to let goods pass, will also be controlled, as the Indian government intends to strictly regulate its new high-denomination notes. If goods start passing through custom points as they are supposed to, there will be a boost in our tax revenue.

There is no denying that Nepali people have been parking or investing money in India for a long time. Are there reasons to believe that this tendency will go down now?

There are claims that this move is also an effort towards reducing the use of cash in the Indian economy by promoting electronic transactions. Capital flight from Nepal to India involves cash most of the times.

It is not that you cannot move cash from Nepal to India or vice versa. It is just that the money has to be legitimate and the transaction has to go through formal channels, which will be subject to certain rules like taxation. But given the open border between the two countries, people move their money to India illegally for investment or other purposes. So if India reduces the use of cash, it will deter such activities.

Do we have an estimation of how much Indian currency there is in the Nepali informal sector?

No. And there is no way we can estimate it. Many of our migrant workers go to India for work and they come from all over Nepal. They bring back their earnings in cash and exchange them locally. It is so widespread that it is very difficult to estimate it.

So how should our government help them to exchange the cash they have?

First, the people with illegal holdings should not get to exchange them. This will go a long way in deterring illegal activities through the use of Indian currency. People will now be wary of using Indian notes.

Second, most of the people with legitimate holdings of Indian currency reside in the border areas, and many of them have bank accounts in India. Even the ones who do not have a bank account can easily cross the border and exchange their cash. They have more than a month to do it. The government needs to focus on the ones who do not have any connections in India. So the NRB should publish a notice and let private banking institutions exchange people’s money. Those working in India also have time till December 30 to exchange their money in India.

Another group of people who might have some big IC notes are those living in remote tourist destinations. However, they might be living very far from district headquarters and would need some extra days to reach a banking institution. So the government needs to keep that in mind as well while planning an exchange facility.

Some claim that the Modi government wants to deter illegal political financing and curb corruption through its move. Should Nepal follow suit?

In 1978 the Janata Party coalition had decided to scrap Rs 1,000, Rs5,000 and Rs 10,000 notes. The move was directed at freezing the secret funds of politicians, especially those from the Indian National Congress party. But the move did not really help reduce corruption back then, and Modi’s recent move might not make much of difference this time around either. People involved in illegal activities are smart and know how to get around the law.

Most of the people involved in illegal activities in recent times do not hold cash for too long. They convert them into fixed assets like property or gold. When the Indian government recently announced its decision, people hurriedly bought gold. Similarly, people have till December to convert their cash and they can easily use poor labourers to get their work done. Yes if they have very large holdings, then it might be difficult.

Demonetisation of currency, as a principle, is a poor economic policy which is not effective in curbing corruption. I would not recommend our government to do something this rash. We will only be inviting trouble and panic by doing so. Anyways in Nepal, I do not think people have a tendency to hoard cash due to security concerns. Moreover, as we spent substantial time debating the Money Laundering Act, many people hoarding illegal cash got the time to convert it into property or make an investment. In addition, as financial cooperatives do not screen their customers, people can easily deposit their illegal earnings in a cooperative. If you look at our money supply to GDP ratio, it fares better than in India. This means that there is a substantial amount of illegal money is in our formal economy.