For demonetization to be successful, adequate remonetization will be necessary

Written By: Ken Gichinga
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In November 2016, Prime Minister Narendra Modi, in a surprise announcement, declared that the 500 and 1000-rupee notes would be banned in four hours’ time
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Last weekend’s Madaraka Day celebration delivered unusual excitement to Kenyans following the announcement by the Central Bank Governor, that a new generation currency had been introduced to replace the old one. Of equal importance, was the additional pronouncement that the one-thousand-shilling note will be withdrawn from circulation in early October.

This is in keeping with a heightened war on corruption, whose illicit proceeds have been stashed in hidden locations, causing cash shortages that are crippling the economy. And for this, we commend President Kenyatta for a truly bold initiative.

In the next few months, economists shall pay close attention to how the Central Bank of Kenya will navigate the sensitive process of demonetization, which has experienced both success and failures in different countries. So why have some countries successfully executed demonetization while others have miserably failed at it?

The simple answer is that money has three distinct functions. It serves as a medium of exchange, as a store of value and as a unit of account. Countries that have successfully conducted demonetization, have effectively managed to change the medium of exchange without significantly disrupting the stored value. This is typically achieved through an efficient process of remonetisation, which is the process of introducing new currency to ensure that total money supply in the economy remains steady.

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Australia is a shining example of how a country can demonetize and remonetize in an efficient way that minimizes any disruptions to the public. In 1996, faced with a similar set of challenges around fraud and counterfeits, the Australian government chose to withdraw its paper-based notes and became the first country to adopt polymer-based notes. With a singular purpose of replacing paper with plastic, the government was clear that only the medium of exchange was changing, and it made every effort to ensure that stored economic value was conserved through an aggressive remonetisation process.

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Similarly, the European Union (EU) demonstrated how successful demonetization is achieved when 12 EU countries did away with their national currencies and adopted the Euro on January 1st 2000. The European Central Bank prepared for almost three years while participating countries distributed 8 billion notes and 38 billion coins through banks, post offices and sales outlets making it arguably one of the most aggressive remonetisation exercises in monetary history.

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However, countries that have poorly managed demonetization have ended up causing untold pain and destruction to their citizenry. In this respect, India provides powerful lessons on the difficulties that can arise when demonetization is bungled.

In November 2016, Prime Minister Narendra Modi, in a surprise announcement, declared that the 500 and 1000-rupee notes would be banned in four hours’ time.

People were given several weeks to exchange their demonetised currency for new notes at banks. But new notes could not be printed fast enough, and the policy sparked a months-long currency crunch, costing India over 1.5 million jobs and wiping off at least 1 percent from the country’s GDP.

The United States also bore the brunt of poor demonetization. The Coinage Act of 1873 demonetized silver in favour of adopting the gold standard as the legal tender of the United States. The withdrawal of silver from the economy, was not counterbalanced by any form of remonetization resulting in a contraction of the money supply, which subsequently led to a 5-year economic depression in the country. In response to the dire situation and pressure from silver miners and farmers, the Bland-Allison Act remonetized silver as legal tender in 1878.

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Reflecting on the economic hardships that arose after the demonetization of silver, Senator John Reagan would later on write “I am persuaded history will write it down as the greatest legislative crime and the most stupendous conspiracy against the welfare of the people of the United States, which this or any other age has witnessed.” Senator William Stewart would add that “the demonetization of silver was the crime of the nineteenth century.”

In the final analysis, the key formulators of Kenya’s monetary policy are invited to consider both the positive and negative outcomes that different countries have experienced when conducting demonetization. The balance of evidence suggests that the 230 billion shillings that will be withdrawn from the economy on October 1st, will need to be conserved and reintroduced back into the economy in the form of new currency through an efficient process of remonetisation. Anything less, could lead to a contraction of money supply which could unleash powerful deflationary forces.

Ken Gichinga is CEO at Mentoria Economics; Email: kgichinga@gmail.com

The views expressed in this article don’t necessarily represent KBC’s opinion.

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