Rapid changes to currency systems can have unexpected consequences. In the wake of the Indian government's decision to eliminate certain high value bank notes, policymakers are beginning to learn this lesson.
Indian Prime Minister Narendra Modi made a surprise announcement on Nov. 8, in which he declared a ban on the country's largest bills, set to begin the very next morning. This meant that all versions of the 500 and 1,000 rupee notes (worth about $8 and $15, respectively) would be removed from circulation, according to The New York Times. Despite that fact that these were the two largest bills, they collectively represented about 80 percent of all currency in circulation.
A shock to the system
Modi claimed that the removal of these notes would help to cut down on India's corruption and tax evasion. His government argued that criminal organizations tend to rely on the largest bills to fund their activities, and also noted that these bills tend to be ripe targets for counterfeiting. Throughout the rest of this year, Modi said that Indians will be able to exchange any of the now-defunct bills for smaller denominations – 100 rupees or below – that are being introduced.
However, criminals and tax cheats won't be the only ones affected by this shift. India is heavily dependent on cash for most transactions – more so than most Western nations. A report by Google India and the Boston Consulting Group found that 78 percent of transactions made in India last year were in cash form, compared to about 20-25 percent in the U.S. and the U.K. In addition, Forbes reported that an estimated 600 million Indians lack bank accounts and rely on cash for all of their economic activity. That's about half of the nation's population.
Many Indians were shocked by the sudden change. One person told The New York Times that he had to stand in line at a nearby bank for six hours to exchange his money for new bills – only to find out that the bank had run out of cash while he waited.
"Modi's reform may hit Indians by putting the future of microlending platforms in doubt."
How will the change affect lending?
Though the notion of cracking down on crime appears to be popular, these changes have hit low income and rural households the hardest, as they tend to hold on to cash and have the least access to financial institutions. Forbes reported that in the wake of the change, barter economics have grown more popular in rural areas, and many weddings have been called off as families try to find new ways to pay for the festivities. In addition, the change has put additional pressure on India's manufacturing sector, and forced stocks below their 200-day moving averages, according to the report.
One way that Modi's reform may hit Indians is by putting the future of microlending platforms in doubt. The Economic Times reported that these institutions have temporarily stopped issuing loans in response to a sudden drop in the repayment rate.
More than most in the finance industry, microlending platforms commonly issue small loans to low income individuals and are heavily reliant on cash. This sudden disruption has left them wondering how to proceed. This is true for lenders all across the country, but especially so for those located in rural areas.
"We need clarity whether the institutions can collect Rs 500 or Rs 1000 notes from their borrowers as repayments of loans or not," Microfinance Institutions Network CEO Ratna Viswanathan told the news source. "We are not sure about it."
Even when the currency transition is complete, Live Mint pointed out that microlenders still face regulations on how much they can withdraw from the banks where they have accounts. Those that survive may have to restructure into small banks themselves.