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The move by the government to demonetize Rs.500 and Rs.1000 notes by replacing them with new Rs.500 and Rs.2000 notes has taken the country with surprise. The government is to tackle the menace of black money, corruption, terror funding and fake currency. From a market perspective, we think that this is a very welcome move by the government and which has taken the black money hoarders with surprise. The total value of old Rs.500 and Rs.1000 notes in the circulation is to the tune of Rs.14.2 trillion, which is about 85% of the total value of currency in circulation. This means that the total cash has to now pass though the formal banking channels to get legitimacy.
The World Bank in July, 2010 estimated the size of the shadow economy for India at 20.7% of the Gross Domestic Product (GDP) in 1999 and rising to 23.2% in 2007. Assuming that this figure has not risen since then (quite unlikely though) and that the cash component of the shadow economy is also proportional estimated unaccounted value of the currency could be to the tune of Rs.3.3 trillion. Now, post the announcement of demonetization by the government this money would have to either account by paying the relevant tax and penalties or would get extinguished. There are higher chances of larger proportion of this unaccounted currency getting as the tax rate and subsequent legal issues could be prohibitively high for such money.
Questions began to emerge. Will it be effective if people can still create new black money thereafter! Will it increase the GDP! Will it increase inflation! What about tax revenues! We look for answers. In India, the Rs 500 and Rs 1,000 notes also constitute a huge percentage of the money spent by governments, political parties and candidates during general elections. A Centre for Media Studies report showed that nearly Rs 30,000 crore was spent during the 2014 general election, while official spending only accounted for Rs 7,000-Rs 8,000 crore.
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