Demonetization: What Kenya could gain and lose

By Faith Nyabuto & Shengwei Luo

In an effort to tackle corruption and money laundering, Kenya will soon embark on a path of demonetization.

As of 1st October 2019, over 200 million 1,000 shillings notes – the largest denomination of the country’s currency — in circulation will be discontinued after a four-month phase out. Kenyan activists such as Okiya Omtata and East African Legislative Assembly MP, Simon Mbugua, have been outspoken in their opposition to the plan in court and parliament.

This announcement follows India’s well-documented demonetization in November 2016 which sparked an acute shortage of cash and had negative effects on economic growth, resulting in a loss of over 1.5 million jobs. Given the failures of India’s demonetization drive, will similar efforts in Kenya be successful?  With a weaker economy than that of India, critics have raised concern that the country is less equipped to weather the initial shock of demonetization.

Through a comparative analysis of demonetization drives in Ghana, India, the Philippines and Pakistan, this brief seeks to assess the potential economic effects of demonetization for Kenya. It indicates that a demonetization policy can considerably reduce illicit financial transactions and counterfeit notes through prudent policy choices. The brief also provides recommendations for policymakers regarding how to mitigate these risks.

Demonetization has been used by developed and developing countries alike as an administrative instrument to improve the central bank’s management of currency in circulation. In theory, demonetization allows for adjustments in the quantity of money in circulation and reduces the chances of counterfeiting.  It also aims to encourage individuals holding funds in the black market to give up their holdings, and helps tax authorities in detecting funds once this “black cash” is deposited in the banking system.

In the Indian case, Prime Minister Narendra Modi also stated that the policy would help spur progress towards a “digital India”, with banks and non-cash business playing an increasingly significant role in financial inclusion.

Despite  these  aforementioned  conventionally accepted benefits, there has been no conclusive proof to support their effectiveness in practice in India,   the   most   recent   high-profile demonetization drive. The Indian case suggests that  demonetization  is  not  a  fundamental solution to black money and corruption

Data from the Reserve Bank of India following the  demonetization  process showed  that  the number  of  counterfeit  notes  did  not  drop significantly after the demonetization process as counterfeiters  were  soon  able  to  replicate  the new 500/2000 rupee notes.The  government  failed  to  achieve  the  aim  of purging  black  money  from  the  economy.

. On  1st  June  2019,  Central  Bank  of  Kenya Governor Dr.  Patrick  Njoroge  announced  the roll-out  of  new  KSh  1,000  notes  over  a four-month   period.   Notes   with   other denominations  do  not  have  an  exchange deadline.  Irrespective  of ongoing  controversyover the use of the likeness of former presidents on  existing  notes,  the  Central  Bank  of  Kenya (CBK) stated that the objective of withdrawing old KSh 1,000 notes from circulation was to counter the  rising  cases  of  illicit  financial  transactions and counterfeit notes.

There  appear  to  be  good  grounds  for  CBK’s concern.  Kenya has  becomea  hub  for  fakecurrency,while  a  report  by  the  Partnership  for African Social and Governance Research on illicitfinancial flows in Kenyasuggests that Kenya’s financial sector is vulnerable given its strategic positioning  in  the  region,  facilitated  by  easy access  through  sea  ports,  airports  and  land. Furthermore,  Kenya performs  poorly  on anti-corruption, ranking 144 among 180 countries in Transparency International’s 2018 CorruptionPerceptions Index.

Kenya’s demonetization strategy shared similar aims to that of India and the Philippines. Based on Kenya’s political economy and approach to demonetization, will it enjoy the relative success of  the  Philippines,  or  suffer  as  India  did? Furthermore, what are the chances of unintended negative consequences also being realized?

Sufficient transition period for exchanging new notes, including the policy and regulatory flexibility to potentially extend the original deadline as required. Our comparative analysis of demonetization drives in Ghana, India, the Philippines and Pakistan suggests a minimum window of three months. To allow for necessary economic adjustments and reduce potential negative impacts, governments should consider implementation periods on a multi-year basis.

To curb illicit financial flows and counterfeit notes — one of the core aims of Kenya’s recent demonetization drive. Botho recommends that the government pursue administrative strategies in concert with the judiciary and private sector instead of relying heavily.

By Faith Nyabuto, Analytics Lead, and Shengwei Luo, Intern at Botho Emerging Markets Group