Demonetization is a terrible idea

Shabbar Zaidi is pushing cuckoo economics that would have devastating consequences for Pakistan's economy.

Ever since he came on Twitter, Shabbar Zaidi has been pushing one crazy idea after another. The most recent one is with regards to declaring Rs. 5,000 notes as illegal tender, which is basically a “soft” version of the demonetization we saw in India.

Before I share my opinion on this, here is some data from a Business Recorder article published on February 3, 2021:

The ratio of CIC to M2 (broad money) on average was 23 percent (FY01-FY06) six years prior to introduction of Rs5,000 and the ratio was 22 percent (FY07-12) six years after it. In fact, the ratio fell after the Rs5,000 note was introduced in May 2006. The ratio was 23 percent in June 2015. In July 2016, the banking transaction tax was imposed and the government efforts to discriminate between filers and non-filers in terms of taxation were expedited. The ratio increased to 26 percent by June 2016. This means markets reacted to the government efforts and transactions sped up in the informal sector. The ratio started inching up since then and reached 28 percent by June 2019. Then Shabbar came and new efforts to curb undocumentation were introduced – the ratio increased to 29 percent by June 2020 – some role has been played by COVID in this – visible from Indian data too.

Basically, the data shows that 5,000 rupee notes have had no direct and visible impact on the amount of cash in circulation in the economy.

Across the border, the Modi government tried a similar move to combat corruption, something with Mr. Zaidi also wants to combat in Pakistan. This is what Modi said to justify his move:

To break the grip of corruption and black money, we have decided that the five hundred rupee and thousand rupee currency notes presently in use will no longer be legal tender from midnight tonight, that is 8th November 2016. This means that these notes will not be acceptable for transactions from midnight onwards. The five hundred and thousand rupee notes hoarded by anti-national and anti-social elements will become just worthless pieces of paper. The rights and the interests of honest, hard-working people will be fully protected.

But it did not have the intended effect, and over 99 percent of the currency declared as illegal tender coming back into the banking system. In fact, the country’s chief economic adviser at the time, Arvind Subramanian, later called it a “massive, draconian, monetary shock.”

Prime Minister Khan, do not listen to Mr. Zaidi.

What Mr. Zaidi is pushing is going to have a terrible impact on Pakistan’s economy, particularly the informal part of it. Dr. M. Ali Kemal, who I have interviewed on the podcast, has written a research paper estimating the size of the informal economy, which is roughly 40 percent of the country’s GDP.

This informal economy, argues Dr. Kemal, exists not because of just corruption and criminal activity. It exists because of a high burden of taxes, high level of regulation, poor public services, and a lack of trust in institutions.

In short, people run away from documentation because they do not have any incentives to be a part of the formal economy. Rather than providing incentives and improving service delivery to reinforce the social contract and incentivize formalization, folks like Mr. Zaidi want to use more sticks on the country’s citizens.

This will not work. In fact, if such a move were to occur, we will quickly see economic activity come to a grinding halt, potentially ushering in yet another recession that leads to loss of jobs and incomes for millions of citizens.