How change of currency notes affects economy

The unveiling of new generation currency notes on May 31,2019 marked major milestones in Kenya’s banking sector and the wider economy. First, it marked a fundamental fulfillment of Article 231 sections (2) and (4) of the Constitution of Kenya 2010. Besides, the features of the new notes also enhance inclusivity as majority of persons, including the visually impaired can knowingly transact. It may be recalled that litigations during the procurement for printing the new currencies delayed their issuance initially planned for 2015.

Second, the new currencies embody enhanced security features which can effectively deter if not minimise illicit financial transactions in counterfeits and laundering. Third, and equally important was the move to purge “black money” from mainstream economy or demonetisation of the Kenya shilling.

According to the Central Bank of Kenya, the Sh1,000 notes, which is the largest currency bill, are widely being used for illicit financial transactions and forgery in domestic market and the neighbouring countries. The last two motives are ostensibly geared towards curtailing further expansion of the underground or parallel economy.

But what exactly is demonetisation and what are its intended benefits? Demonetistion is the withdrawal of coins, notes or even precious metals from use as legal tender through change in national currency. It involves replacement of old with new currency. From perspectives of monetary policy, demonetisation has several possible benefits.

For instance, when a currency is demonetised, people tend to deposit cash with banks and therefore keep less at home. This helps encourage a savings and investments culture in the private sector. The raises the chances of the government collecting more revenues and therefore spending more on public investments.

Demonetisation can help the government to curb anti-social or criminal activities including smuggling, terrorism, counterfeiting, tax evasion and wanton corruption. Thus, the central bank can strengthen its control over the currencies in circulation and smoke out old unaccounted-for from the mainstream economy.

There are several transmission channels which make it difficult to predict the ultimate outcomes of demonetisation in the Kenyan economy. For instance, whereas increased movement of money between people, banks and other financial institutions is expected to translate into lower lending rates, this cannot be automatically guaranteed under regulated environments as is apparent in the interest rate cap.

The other anticipated short run impact is on inflation or the rise in general prices. This may be triggered by the rush to get rid of the old currencies leading to increased liquidity and putting inflationary pressure on prices of inputs, intermediate products and finished goods and services.

Furthermore, disruptions in production could also take place especially in sectors that intensively rely on labour, like construction, textiles and transportation in the forms of reduced wages and loss of work. The situation may be worsened if the illicit monies are into the economy as anti-social units seek to sanitise them. But it is also possible to realise lower inflation rates should aggregated demand in the economy be dampened due to shortages in production. From the external side, the Kenya shilling is likely to depreciate due to increased demand for foreign currencies.

This could worsen trade balances as import would become cheaper and exports more expensive thereby reducing the country’s competitiveness in production and external markets. Cross-border traders could also suffer in the short-run should regional central banks freeze trade in the Kenya shilling as a precautionary measure to prevent illicit financial flows into those markets.

Shadowy transactions activities may be illegal, like cases of frauds, drug dealings, counterfeiting and money laundering and thrive best under weaknesses in enforcement of laws and regulations, impunity or disrespect on rule of law as well as eroded ethical values.

They could also be legal activities performed out of the gaze of the taxman. For instance, businesses operating without securing requisite permits and licences or non-declaration of incomes to revenue authority for services rendered to clients. Such activities are motivated by presence of excessive taxes, punitive regulatory laws and policies, price controls and related measures which interfere with free market operations.

Overall, previous research findings from many countries suggest the driving forces behind growth of parallel economies as being increasing burden of taxes and restrictive regulations, including cumbersome registration of businesses, non-tariff barriers to trade and labour and financial markets and weak institutions.

Indeed, heavily regulated economies combined with weak regulatory an administrative system are fertile grounds for the underground economy. That these are the same conditions under which corruption also thrives is a basis for the argument that demonetization can be a tool to fight corruption hold, at least partially.

There is no doubt that the expansion of the parallel economy is not desirable for the good health of an economy. The un-reported activities escape taxation and therefore keep tax revenues lower than potentials.

This directly constraints total expenditures by the government, draws revenue allocations away from development to recurrent expenditures, and encourages borrowing (domestic and foreign) to fill fiscal deficits. The erosion of the tax base and tax compliance may compel the government to raise taxes which occasion further expansion of the shadowy economy and trigger a destructive cycle. But most importantly, a thriving underground economy renders official statistics on key macroeconomic indicators like Gross Domestic Product, employment, investments, savings, consumption unreliable, hence undermining economic planning and development.

Whether immediate or gradual, the effectiveness of demonetization depends on several factors. Immediate demonetization may be more effective in cleaning up illicit money in the sense that actors have limited time and options to release and/or transact hoarded monies. However, it has devastating effects on the general economy with the ordinary people, especially the poor bearing the brunt as experienced in Ghana (1982), India (2016), North Korea (2010) and Venezuela (2017). On the contrary, gradual demonetization may allow for adjustments as short- term measures to reduce the negative impacts may be undertaken. However, it is less effective on its own in ridding-off illicit cash holdings in individual hands who have options of converting such into foreign currencies, real estate and other properties.

The Central Bank of Kenya has taken a gradualist approach to demonetization in the bid to reduce likely negative impacts on the economy and strengthen its control of the financial sector. Sustainable reduction of the size of the underground economy will require effective coordination with other public agencies and streaming financial laws and regulations with those of other sectors of the economy.

This will require strengthening the multi-pronged approach in the fight against corruption, whereby all public agencies, the legislature and judiciary effectively discharge their respective mandates and responsibilities.

Second, although Kenya’s performance in the ease of doing business has been consistently improving over the last two decades, improving the business environment, especially the registration and taxation regimes must be sustained. Restrictive financial regulatory regimes tend to reduce compliance and generate spill-over effects in other sectors. For instance, whereas the existing laws and regulations on cash withdrawals and deposits are intended to curb illicit transactions, they may at the same time discourage genuine investments.

Third, strengthening governance and associated institutions are central to the fight against corruption and by extension the parallel economy. In this regard, effective control of regulations relating to public procurement and effective oversights of public expenditures at national and county governments and meting out severe punishment or punitive measures against anti-social behaviors.

Finally, there is need to scale-up investments in collection and management of financial and related data at all levels of governments. An integrated financial information system can help establish or estimate the number of people actively involved in the parallel economy, how often these activities occur and the size of these activities to improve decision making and effectiveness of various policies.

The writer is a Principal Policy Analyst at the Kenya Institute for Public Policy Research and Analysis.