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Demonetization Broom: How it Swept Other Economies Before
Demonetization Broom: How it Swept Other Economies Before
Posted

By - Kiraithe Daniel Mutemi

Posted - 06-08-2019

“Demonetization” simply refers to the withdrawal of a national currency from circulation stripping that unit of its legal tender status. This pulling of money from circulation is often seamlessly followed by a complete replacement of the old affected units with new notes or coins. On the other hand, restoring the withdrawn form of payment as a legal tender is “remonetization,” which is doing precisely the opposite of demonetization. Demonetization is an economic tool used in drastic situations and can cause severe economic downturn if it is not well managed.

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When the Central Bank of Kenya (CBK) Governor Dr Patrick Njoroge (pictured below) announced this move in Kenya on June 1, 2019, it left many shocked as it was not only unforeseen by experts but also unheard of by majority common currency users.

The Central Bank f Kenya (CBK) Holding the New Currency Notes.

Although the change of currency was anticipated in Kenya to ensure the notes and coins are compliant according to Article 231 sections (2) and (4) of the Constitution of Kenya 2010, demonetization was not expected. The unveiling of the new generation currency was followed by an announcement that the KES 1,000 notes would cease to be used as legal tender exactly four months from June 1, 2019.

This drastic measure is often taken to manage inflation by stabilizing the currency, to wipe out black markets in an economy, to facilitate cross border trade and market access as well as fight corruption in some instances.

U.S. A
Demonetization has been in existence from as late as 1873 when the United States withdrew silver and adopted gold standards. Demonetization of the silver as the legal tender was aimed at managing the hyperinflation. There were substantial silver deposits which necessitated the withdrawal of several pieces resulting in sharp money supply contraction. The contraction led in a recession which was, in turn, met by political chaos as farmers and silver miners demanded value for their products. This stalemate ended five years later by the Bland-Allison Act that remonetized silver restoring its legal tender status.

The gold standards adopted rendered silver medium of exchange useless without allowing people to exchange them for the new legal tender. There was, therefore, less money in circulation since the equivalent amount of gold was not available. Trade was adversely affected, and a decline in GDP was hitting the economy hard. Deflation that resulted from the use of this tool was undesirable and thus sparked social, economic problems that were manifested politically.

India

India has walked the path of demonetization several times. The Reserve Bank of India carried this drastic measure in 1946 by demonetizing Rs 1,000 and Rs 10,000 notes. Equally, the government introduced new banknotes in 1954, and the notes were again demonetized in 1978 as the government was pressed to curb illegal transactions and other social-economic vices.

Most recently, in 2016, in the most drastic demonetization exercise, the government of India withdrew Rs. 500 and Rs 1,000 abruptly. The prime minister cited objectives such as unearthing black money, destroying terrorism financing, managing interest rates, and formalizing the country’s informal economy by discouraging cash transactions. Implementing a digital economy was thus at the centre of the argument by the government.

It is reported that 99 per cent of the money found its way back into the system even with the short period citizens had to return the units. This exercise, therefore, achieved little or nothing in curbing illegal and illicit businesses. However, cashless transactions were adopted much more than before.

Zimbabwe

Zimbabwe also demonetized her currency in 2015 to tame runaway inflation that had surged 231,000,000 per cent. This hyperinflation forced the government to wipe out the country’s dollar that was almost useless in the financial transactions to replace it with the U.S. Dollar. Although it was carried out in three months, there was a substantial speed in the exercise that hurt the wealth holders by turning their accumulated wealth valueless in such a short time. It, however, reduced inflation and achieved a significant short term financial stability. The economy was depressed as Zimbabwe’s exports lacked competitiveness when the country adopted foreign currency (USD). Zimbabwe’s inflation rate in June 2019 was 175 percent, one of the highest in the world.

European Union

Euro was adopted in 2002 by European Union member countries who demonetized their currencies to facilitate trade. This process was carried out successfully ensuring the currencies initially used by individual member countries were convertible at a fixed exchange rate into the new currency; Euro. There were no incidences of people losing wealth due to the withdrawal of national money from the financial system. Such currencies were French franc and the German mark.

Kenya

The announcement that Kenya would no longer accept the old KES 1,000 note beginning October 1, 2019, means those who have these notes must return them to the banks before the said date. However, the other denominations will continue to be acceptable legal tender in the country. This step is mainly aimed at fighting corruption and illicit money than stabilizing economy since the inflation rates are within the government’s targets. Will this strategy achieve much?

The CBK issued guidelines in 2018 regarding the withdrawal and deposits of KES 1,000,000 (10,000 USD) and above to have them reported. These guidelines restrict such transactions in any bank without reporting to the Financial Reporting Centre (FRC) whether they are suspicious or not. Therefore, any deposit that an individual will make in an attempt to put the ill-gotten money in the financial system will be flagged if it reaches this threshold.

It is estimated that there are 218,000,000 notes of KES 1,000, meaning KES 218 Billion are in the form of those notes. If one has to deposit a maximum of KES 1 million each day for the 120 days given, it means one can only deposit back to the system KES 120 Million. However, there are many corruption suspects holding more than this amount in cash. It will, therefore, be a new invention for the holders of such money to circumnavigate demonetization by the CBK. Achieving the exact results intended by this method seems a mirage as crime become more sophisticated every day.

There has been increased spending in the economy since this announcement was made signalling how people are keen to spend the targeted units. This increased velocity of money may manifest in an oversupply of money, causing inflation to go up. According to the data in the CBK website, in July 2019, the annual average inflation rate increased to 5.32 per cent from 5.16 per cent observed in June 2019.

Lessons

Demonetization aims to improve the economy by instilling better saving culture, lowering lending interest rates, managing inflation, minimizing counterfeit money, curbing antisocial activities and illicit trade. Additionally, demonetization has been used to target combating corruption and economic crimes such as tax evasion. However, these results may not be achieved depending on the choice of time, and the implementation process adopted.

The time given to implement the demonetization process is critical. Enough time to exchange the currency is necessary to avoid wealth loss that may result in political pressures. Doing it in a hurry can cause more social-economic problems than the gains achieved.

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Free exchange should be made available at all banks. Where such a provision is not adequate, average people who may not be closer to banks may suffer more as they try to comply within a short period. Also, the aim that the process aims to achieve should guide the implementation to avoid undesired results due to the inappropriate strategies used. Different circumstances may make different results thus, caution must be exercised when demonetizing or remonetizing a country or region’s currency. If the economic policymakers have to use this broom, they must be aware of their unique environment and expect results that vary from place to place.

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