Demonetization Gets Rid of Black Money is a Fallacy
Category: Economic Policy
By: Kwame Owino,
Sometime in the middle of the decade after 2010, a number of countries chose to use the high-sounding policy choice of demonetization. This fad captured the imagination not only of policymakers but also of many citizens. In essence, demonetization is the policy choice of ensuring the obsolescence of state-issued currency denomination against a tight timeline of a few months or less. The literature shows that three main reasons are often cited for this policy measure.
The first is where a statute or law expressly requires the replacement of a currency. In this case, the obsolescence of the chosen denomination of fiat currency is driven by a statute or constitutional command. In this instance, the underlying reason may be to update the currency by issuing a new material to replace the paper or features embedded on the face of the currency in order to ensure the durability or to raise the cost of illegal duplication or counterfeiting. The second case is often because a government is compelled to reissue currency because the economy has undergone persistent hyperinflation that makes the currency worthless and therefore needs replacement. The third reason and the relevant one for the fallacy being addressed is the recent fad of 2010s when governments sold demonetization policy as a solution to crime. The crime control angle is predicated on the reasoning that most of the criminal enterprises depend on transaction through cash and therefore to change the currency without prior warning would render cash reserves held by these enterprises either unstable or compel criminals to expose their culpability by having to declare the sources of their cash prior to making deposits in regular retail banking facilities.
Kenya’s most recent demonetization started in 2019 and was predicated on the constitutional requirement under article 234 (4) which commands the central bank of Kenya to ensure that “notes and coins” shall not bear the portrait of an individual. Full compliance with this policy was due by the fifth anniversary of the passage of the constitution of 2010 but this deadline was extended, leading to the 2019 commencement of demonetization. While this was sufficient reason for institution of the demonetization policy, several state offices and some communication from the Central Bank of Kenya, suggested that the demonetization would also help to expunge black money from the Kenyan economy.
With respect to the specifics, the demonetization approach used by Kenya was akin to that implemented by the Indian government in 2016 except that the former provided an extended period of three months instead of an immediate declaration of the invalidity of its largest currency denomination. Specifically, the CBK declared that the highest denomination notes in Kenya, which is Kshs. 1,000 would not be legal currency within the 4-month period from June 01 to September 30, 2019. All the other denominations would be phased out gradually. Thinking in simple economics theory, the intention of this demonetization was aimed at raising the cost of keeping cash in the highest denomination by forcing disclosure that may lead to either forfeiture or obsolescence of cash whose sources the claimant is unable to account for.
In terms of the identification of the right unit, the focus on escalated obsolescence of the largest denomination currency made sense. In 2019, the 1000 shillings note represented 83.1% of the value of the total legal currency in circulation in Kenya. In turn, the total currency in circulation in Kenya at that time represented The assumption behind the secondary goal of the demonetization policy is that because of the bulk that it represents, most of the illegal wealth kept in cash would be disproportionately in the largest note. In addition, 217.6 million of the total 261.8 million units of paper currency, representing the six currency values (20, 50, 100, 200, 500, 1000) available in Kenya in 2019, were of the highest value, supporting the plausible claim that it would be the most preferred unit for storage of illegally acquired income.
Because the Central Bank of Kenya has a monopoly granted by law for the issuance of currency, it means that any currency that is issued and forfeited because of demonetization would be again for the agent of the government in monetary issuance. At the end of the four-month period, the Central Bank of Kenya reported that 96.35% of the total volume of the largest denomination currency were effectively demonetized, representing 80.08% of the value of all currency in circulation within Kenya in 2019. Noting that the extended policy reason for the demonetization was to reduce the size of black money gained that manifests in illegal financial flows and currency forfeiture, it is difficult to argue that keeping out about 3.75% of that value through demonetization was both cost-effective or a policy success. Indeed, even 3.75% is generous because it takes the assumption that all of the currency that was not surrendered belonged to black market or illicit wealth.
Despite the fact that the Central Bank of Kenya did not declare the threshold upon which they would judge the success of demonetization policy in reducing black market and illicit financial flows (IFFs), it declared that the policy was a success and gave itself a pat on the back. Soon after, the press made revelations of individuals who because of itinerant lives and inadequate access to public information, had lost wealth because they kept vast sums of cash which had now been rendered unusable. It is evident that this situation was more common as only people who had the largest cash savings that had been made worthless would have the incentive to advertise their predicament in the press. This proves that the demonetization policy for the purposes of reducing the black market not only unimpressive in the quantum but also disproportionately affected less savvy and lower-income people.
At the level of economic theory, it is also evident that the tame effects of the demonetization policy were predictable. To begin with, Kenya has a large informal sector in which cash transactions dominate. Thus despite the fact that it would be efficient for a beneficiary of income generated by crime to store the proceeds in the highest currency, the conclusion that an escalated demonetization of the currency would extinguish the stash is fallacious because the currency is not the exclusive form of storage of wealth. All the currency in Kenya in 2019 represented a face value of Kshs. 261.8 billion, equivalent to 2.68% of the Gross Domestic Product at the end of that year. Given that the currency is such a small share of the GDP, it immediately evident that it is clear that forced dilution of demand for one currency type is a cost-effective or even sensible approach to reducing the size of the black market. It is just evident that cash is such a small share of the wealth created in Kenya that most sizeable incomes would be held in other property forms. There is no surprise that the demonetization policy couldn’t achieve much.
Standard economics theory classifies cash as a form of money and which has three attributes including a unit of account, a store of value and a unit of exchange. Having known that the availability of currency in Kenya is a small share of the overall Gross Domestic Product (GDP) it is clear that other forms of storage, exchange and unit of accounts must be available. In demonetization of the Kshs. 1000 note, the policy assumed (naively perhaps) that for the participants of the illicit markets, the cash reserves that individuals had is where the three factors converge. For a comparatively open economy such as Kenya, wealth holders and income earners can resort to storage in different forms such as foreign exchange, precious metals or even real property, even if the first instance of payments comes as cash. The convertibility of cash into various forms of property shows that basic economics understanding would predict that a demonetization policy is unlikely to have the widespread effect or erasing the property of criminals that was anticipated in Kenya.
With the benefit of hindsight, it is also evident that the promise to wipe out the fortunes gained from IFFs and the black money through demonetization failed. It carries unintended consequences in the sense that non-criminals how we’re unable to access banking facilities on time lost substantial amounts of their property. For these people, the demonetization policy was simply an expropriation policy based on a fallacy that demonetization is both an efficient and effective rid a country of black money.
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Demonetization Gets Rid of Black Money is a Fallacy
| Post date: Fri, Apr 30, 2021 |
| Category: Economic Policy |
| By: Kwame Owino, |
Sometime in the middle of the decade after 2010, a number of countries chose to use the high-sounding policy choice of demonetization. This fad captured the imagination not only of policymakers but also of many citizens. In essence, demonetization is the policy choice of ensuring the obsolescence of state-issued currency denomination against a tight timeline of a few months or less. The literature shows that three main reasons are often cited for this policy measure.
The first is where a statute or law expressly requires the replacement of a currency. In this case, the obsolescence of the chosen denomination of fiat currency is driven by a statute or constitutional command. In this instance, the underlying reason may be to update the currency by issuing a new material to replace the paper or features embedded on the face of the currency in order to ensure the durability or to raise the cost of illegal duplication or counterfeiting. The second case is often because a government is compelled to reissue currency because the economy has undergone persistent hyperinflation that makes the currency worthless and therefore needs replacement. The third reason and the relevant one for the fallacy being addressed is the recent fad of 2010s when governments sold demonetization policy as a solution to crime. The crime control angle is predicated on the reasoning that most of the criminal enterprises depend on transaction through cash and therefore to change the currency without prior warning would render cash reserves held by these enterprises either unstable or compel criminals to expose their culpability by having to declare the sources of their cash prior to making deposits in regular retail banking facilities.
Kenya’s most recent demonetization started in 2019 and was predicated on the constitutional requirement under article 234 (4) which commands the central bank of Kenya to ensure that “notes and coins” shall not bear the portrait of an individual. Full compliance with this policy was due by the fifth anniversary of the passage of the constitution of 2010 but this deadline was extended, leading to the 2019 commencement of demonetization. While this was sufficient reason for institution of the demonetization policy, several state offices and some communication from the Central Bank of Kenya, suggested that the demonetization would also help to expunge black money from the Kenyan economy.
With respect to the specifics, the demonetization approach used by Kenya was akin to that implemented by the Indian government in 2016 except that the former provided an extended period of three months instead of an immediate declaration of the invalidity of its largest currency denomination. Specifically, the CBK declared that the highest denomination notes in Kenya, which is Kshs. 1,000 would not be legal currency within the 4-month period from June 01 to September 30, 2019. All the other denominations would be phased out gradually. Thinking in simple economics theory, the intention of this demonetization was aimed at raising the cost of keeping cash in the highest denomination by forcing disclosure that may lead to either forfeiture or obsolescence of cash whose sources the claimant is unable to account for.
In terms of the identification of the right unit, the focus on escalated obsolescence of the largest denomination currency made sense. In 2019, the 1000 shillings note represented 83.1% of the value of the total legal currency in circulation in Kenya. In turn, the total currency in circulation in Kenya at that time represented The assumption behind the secondary goal of the demonetization policy is that because of the bulk that it represents, most of the illegal wealth kept in cash would be disproportionately in the largest note. In addition, 217.6 million of the total 261.8 million units of paper currency, representing the six currency values (20, 50, 100, 200, 500, 1000) available in Kenya in 2019, were of the highest value, supporting the plausible claim that it would be the most preferred unit for storage of illegally acquired income.
Because the Central Bank of Kenya has a monopoly granted by law for the issuance of currency, it means that any currency that is issued and forfeited because of demonetization would be again for the agent of the government in monetary issuance. At the end of the four-month period, the Central Bank of Kenya reported that 96.35% of the total volume of the largest denomination currency were effectively demonetized, representing 80.08% of the value of all currency in circulation within Kenya in 2019. Noting that the extended policy reason for the demonetization was to reduce the size of black money gained that manifests in illegal financial flows and currency forfeiture, it is difficult to argue that keeping out about 3.75% of that value through demonetization was both cost-effective or a policy success. Indeed, even 3.75% is generous because it takes the assumption that all of the currency that was not surrendered belonged to black market or illicit wealth.
Despite the fact that the Central Bank of Kenya did not declare the threshold upon which they would judge the success of demonetization policy in reducing black market and illicit financial flows (IFFs), it declared that the policy was a success and gave itself a pat on the back. Soon after, the press made revelations of individuals who because of itinerant lives and inadequate access to public information, had lost wealth because they kept vast sums of cash which had now been rendered unusable. It is evident that this situation was more common as only people who had the largest cash savings that had been made worthless would have the incentive to advertise their predicament in the press. This proves that the demonetization policy for the purposes of reducing the black market not only unimpressive in the quantum but also disproportionately affected less savvy and lower-income people.
At the level of economic theory, it is also evident that the tame effects of the demonetization policy were predictable. To begin with, Kenya has a large informal sector in which cash transactions dominate. Thus despite the fact that it would be efficient for a beneficiary of income generated by crime to store the proceeds in the highest currency, the conclusion that an escalated demonetization of the currency would extinguish the stash is fallacious because the currency is not the exclusive form of storage of wealth. All the currency in Kenya in 2019 represented a face value of Kshs. 261.8 billion, equivalent to 2.68% of the Gross Domestic Product at the end of that year. Given that the currency is such a small share of the GDP, it immediately evident that it is clear that forced dilution of demand for one currency type is a cost-effective or even sensible approach to reducing the size of the black market. It is just evident that cash is such a small share of the wealth created in Kenya that most sizeable incomes would be held in other property forms. There is no surprise that the demonetization policy couldn’t achieve much.
Standard economics theory classifies cash as a form of money and which has three attributes including a unit of account, a store of value and a unit of exchange. Having known that the availability of currency in Kenya is a small share of the overall Gross Domestic Product (GDP) it is clear that other forms of storage, exchange and unit of accounts must be available. In demonetization of the Kshs. 1000 note, the policy assumed (naively perhaps) that for the participants of the illicit markets, the cash reserves that individuals had is where the three factors converge. For a comparatively open economy such as Kenya, wealth holders and income earners can resort to storage in different forms such as foreign exchange, precious metals or even real property, even if the first instance of payments comes as cash. The convertibility of cash into various forms of property shows that basic economics understanding would predict that a demonetization policy is unlikely to have the widespread effect or erasing the property of criminals that was anticipated in Kenya.
With the benefit of hindsight, it is also evident that the promise to wipe out the fortunes gained from IFFs and the black money through demonetization failed. It carries unintended consequences in the sense that non-criminals how we’re unable to access banking facilities on time lost substantial amounts of their property. For these people, the demonetization policy was simply an expropriation policy based on a fallacy that demonetization is both an efficient and effective rid a country of black money.
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Introduction The matatu metaphor can be used to analytically frame Kenya’s budget as a system that is subject to binding constraints, evolving expectations, and continuous adjustment to shocks. Like the matatu sector, fiscal policy reflects a balancing act between efficiency and quick action seeking to respond to public service delivery while constrained by competing sector […]
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