Can Pakistan Demonetize Its Way Out Of This Crisis?

Can Pakistan Demonetize Its Way Out Of This Crisis?
Pakistan's ongoing economic struggles have led experts to propose various solutions to improve the country's economy. Recently, social media and television have been discussing the negative effects of an inflated money supply in the country, and the potential of demonetization as a solution.

Despite successive interest rate hikes, Pakistan is still suffering from high levels of inflation, mainly due to the informal cash economy that does not respond systematically to monetary measures. Economist Ammar Habib argues in his articles that the root cause of the problem is the excessive amount of cash in the system. For over three years, the State Bank of Pakistan (SBP) has kept negative real interest rates, leading to trillions of rupees being injected into the market, causing a surge in demand. At present, the country has over Rs 8 trillion, equivalent to almost 20% of the GDP, in circulation, adding to inflation. Hence, redirecting cash from the informal economy to the formal economy is one way to reduce inflation and bring down interest rates in Pakistan. Business and Economy Journalist Ali Khizar suggested in his article that "a reduction of Rs 2 trillion from Rs 8 trillion cash in circulation can generate ample liquidity to lower the interest rates. The government and SBP need to think of a workable option to rein in the cash economy."

Therefore, demonetization seems to be the most feasible option as per many. “Pakistan should go for full demonetization, canceling all currency within an announced period. Cash deposited not previously declared should be taxed at 10-50%, depending on the amount while exempting small deposits. Cash already declared in tax returns should be taxed at 10% adjustable against final liability. This will be needed to avoid misuse,” read a tweet by Najam Ali, a Senior Investment Banker.

However, Dr. Nadeem ul Haq, a renowned economist and the Vice Chancellor of the Pakistan Institute of Development Economics, holds a contrary view, saying that nothing will happen except people scrambling for dollars and gold, devaluing the rupee further, and productivity will still be the same.

Those who oppose demonetization cite India's limited success in implementing the same approach in 2016. Gita Gopinath, Chief Economist at the IMF, stated that India's demonetization, which saw 86% of the currency declared illegal tender, ultimately led to a 2 percentage point reduction in the growth rate of economic activity in the quarter of demonetization. She also said that demonetization was not a good idea for a country like India at its level of development.

However, even though almost 99% of the total currency found its way back to Indian banks, demonetization positively affected the distribution of income, and the tax-to-GDP ratio across the border.

Yet, the impact of a possible demonetization in Pakistan is still uncertain. Advocates, including economist Ammar Khan, acknowledge the significant social and political costs, as well as a hit to GDP. Still, the country might recover and resume economic growth, as India did, through digital payments, tamed inflation, and single-digit interest rates. However, such a process requires that the SBP prioritize price stability by addressing structural inefficiencies and leveraging technology to minimize risks.