India’s Demonetization Disaster

On 08 November 2016, Indian Prime Minister Narendra Modi addressed his nation and unveiled what was billed as a new weapon in the anti-corruption arsenal: the demonetization of the currency notes of Rs 1000 and Rs 500 denominations. This sudden announcement sent ripples across the nation. In few days as people realized that the money and wealth in these denominations will have to be converted as the notes were to be banned, there was chaos everywhere. There was an emergency-like situations with people not sure of how to cope up with the situation that arose. Long queues were witnessed outside ATMs, as the new currency notes slowly started trickling in. Here is a brief analysis of India’s so-called ‘historic’ move:

What is Demonetization?

Demonetization is the process of removing currency from the monetary system by either ending its status as legal tender — meaning banks and businesses do not have to accept it — or simply ceasing to print the currency but still accepting it. For example, the US ceased production of bills greater than $100 during World War II, and though they are still accepted as legal tender, they are not re-circulated after banks accept them. In 2016, India demonetized their highest bills and replaced them with new bills. All such currency needed to be deposited in banks or exchanged for the new bills within 50 days or it would become worthless.

Why Demonetization? 

There are many reasons to demonetize, including addressing inflation, combating black markets and stimulating the economy.

1. Reduces Inflation

Demonetization can reduce inflation by removing money from the market, including counterfeit money or bills that fail to get converted on time, and therefore reducing demand for goods and services. Last year, Venezuela announced the demonetization of their highest bills and the plan to replace them with even larger bills that would keep up with increasing prices; instead of changing inflation’s course, this policy would hopefully make transactions easier because Venezuelans would not have to cart loads of bills to conduct business.

2. Combats Black Market & Tax Evasion

Demonetization can also be a tool to combat black markets and tax evasion. India’s central bank claimed that their demonetization was, in part, motivated to stop terrorist activity that was funded by counterfeit currency. Several other countries have recently considered dropping some of their paper currency or adding new forms of currency to curtail black market exchanges, including Australia, Venezuela and Japan.

3. Stimulates Economy

Another potential benefit from demonetization is a wider array of tools to stimulate the economy. If people hoard large amounts of cash, that money is neither contributing to the economy through spending or through saving, which is important for investment. By forcing that cash to be converted, it has a higher chance of being saved in a bank or being spent. Governments are further frustrated by lost tax revenue. Flushing the cash into the marketplace allows taxes to be levied and collected on those transactions.

4. Effects Better Monetary Policy

Monetary policy could gain new tools to address economic downturns if all currency was demonetized. Because no money would be stored as cash, banks could charge a fee to store money rather than paying interest, which would in effect be a negative interest rate. For example, Japan kept its central bank rate in the red for several quarters, hoping this would encourage spending much like any other decrease in interest rates. During the recovery from the 2008-2009 recession, the US Federal Reserve reached a “zero lower bound” below which the federal funds rate could not drop because banks do not charge negative interest rates, and they had to turn to quantitative easing to boost the economy since they could not slash interest rates any further. Even if only the largest bills were demonetized, it may be possible to have negative interest because it would become difficult to hold money in small bills only; conversely, this could hurt the economy if spenders decided to keep all of their money and conduct all of their transactions with only small bills.

5. Creates Digital Economy 

It’s worth noting that cash is a useful medium of exchange that does not rely on technology. Although it’s easy to use an app to send money to friends, coworkers, or roommates, access to a smartphone should not be a requirement for these or other transactions. Some economies could benefit from using more electronic payments, since they can easily be tracked and taxed. For example, to discourage the use of cash Japan recently announced their plans to introduce a new digital currency that can be used instead of yen. Demonetization can be a useful tool to address major systemic problems, but such a drastic step should not be seen as necessary for healthy economies.

Disadvantages

1. Creates Economic Instability

Although demonetization is often designed to reduce instability, it can cause instability itself. Although Venezuela demonetized their highest bills last year and replaced them with higher bills earlier this year, hyperinflation is still rampant and the new bills have not kept up with the pace of inflation. The transition was marked by uncertainty and distrust of the government and the currency’s value. Demonetization’s destabilizing effects on financial markets can perhaps be seen most clearly through the economic effects of demonetization.

2. Reduces Investments 

Introducing negative interest rates would reduce investment in markets if people were able to pull their money out of banks and store it in cash or convert it to another currency, such as Bitcoin. An economy with less investment has fewer opportunities for businesses to start or expand because of their limited access to funds for loans. Additionally, financial markets do not respond well to uncertainty in monetary policy since models are built on expected interest rates. However, converting to a digital currency could increase the amount of data that financial markets have access to and thereby improve their models — provided that the chosen currencies are easy to track.

3. Causes Economic Downturns

Despite its good intentions, demonetization may not successfully address inflation, black markets or economic downturns. Venezuela and India’s recent policy changes have yet to prove successful. Instead of being stopped by demonetization, black markets can turn to other currencies or digital transactions that can be difficult to trace or regulate. Negative interest rates could prove to be a costly policy decision that central banks would rather avoid than use as a tool. In the wake of bailing out big banks in 2009, policy moves that help banks and hurt citizens are less politically viable.

4. Causes Public Unrest 

The economic effects touch on some of the many costs to consider with demonetization; the primary concern is about transaction costs at the initial stage of demonetization. A well-planned conversion can reduce transition costs by leaving a long period of exchanges. For example, when the Euro was introduced in the European Union, old currency such as the Deutsche Mark was still convertible to the Euro from 1999 to 2002. In contrast, India’s conversion of cash took place in a short window and had high transition costs. Since most Indians held all their money in cash, there were long lines to exchange notes and there were losses to productivity and general unrest, especially in rural areas, during this transition.

Indian Demonetization

In India’s case, the demonetization was aimed at curbing the black money and fake notes by reducing the amount of cash available in the system. The Indian government had also targeted to eradicate corruption, stop terror funding, remove sources of black money and reduce the currency notes in circulation to promote digital payments.

A Coercive Step or a Bold Move?

Supporters of PM Modi and his party, the Bharatya Janata Party (BJP), hailed the step as a good and necessary measure to “clean up the system.” Critics, though, have lambasted it as a “silly” move that caused enormous pain to Indians, particularly those in rural areas with little access to bank branch networks or ATMs.

Former Prime Minister Manmohan Singh, an accomplished economist and the architect of India’s economic liberalization programme, even called it “organized loot” and “legalized plunder.”

Singh also noted, “The damage it [demonetization] has caused has been multiple – economic, social, reputational and institutional. Slowing GDP is merely one indicator of the economic damage. Its impact on the weaker sections of our society and business is far more damaging than any economic indicator can reveal.”

But Modi’s administration disagrees, with Finance Minister Arun Jaitley terming demonetization as “a watershed moment in the history of Indian economy.” In a blog, “A Year After Demonetization,” he said that November 8, 2016 “signifies the resolve of this Government to cure the country from dreaded disease of black money.” Jaitley said the move had met its objective of reducing cash in the economy, ending anonymity of cash, bringing in more individuals in the tax net and dealing a body blow to black money.

A Failed Attempt

India’s surprise move to ban several bank notes, which was aimed at rooting out illicit cash, appeared to have achieved the opposite of its intended goal. The demonetization was nothing more than a temporary demand shock that brought the wheels of commerce to a halt. It is another matter that it failed to achieve its primary objective of mass confiscation of illegal wealth. Demonetization was carried out on the incorrect premise that black money means cash. It was thought that if cash was squeezed out, the black economy would be eliminated. But cash is only one component of black wealth: about 1% of it. In its annual report released on Aug. 30, the Reserve Bank of India said that 99 percent, or around 15.28 trillion rupees ($238.7 billion), of the demonetized 500- and 1,000-rupee notes were deposited or exchanged for new currency. This actually means that either there was no significant black money in cash or hoarders found a way to legitimize most of their ill-gotten cash. That figure also suggests that most people — including corrupt officials, businessmen and criminals said to have hoarded their illicit wealth in cash — have managed to preserve their fortunes.

Black money is a result of black income generation. This is produced by various means which are not affected by the one-shot squeezing out of cash. Any black cash squeezed out by demonetization would then quickly get regenerated. So, there is little impact of demonetization on the black economy, on either wealth or incomes.

Changing Goalposts

The Modi government is highly embarrassed, and to cover it up, it has again changed the goalpost. It now argues that it is good that black money has been deposited in the banks because those depositing it can now be caught. But the government had tried to prevent people from depositing demonetized currency by changing rules during the 50-day period. It is now fighting hard in the Supreme Court against giving one more chance to deposit the demonetized notes that may have been left with the old and the infirm.

The government changed the goalpost earlier in November 2016 when it suggested that the real aim of demonetization was a cashless society. Now it says that idle money has come into the system, the cash-to-GDP ratio will decline, the tax base will expand, and so on. But none of these required demonetization and could and should have been implemented independently. Further, anticipating the failure of demonetization in 2016 itself, the government started saying that demonetization is only one of the many steps to tackle the black economy.

The government’s argument that cash coming back to the banks will enable it to catch the generators of black income, and there will be formalization of the economy, does not hold. Much of the cash in the system is held by the tens of millions of businesses as working capital and by the more than 25 crore households that need it for their day-to-day transactions.

Negative Economic Consequences

The disruption of unorganized supply chains that are dependent on cash transactions; it is still not clear how smoothly they were being rebuilt as the economy was re-monetized.

No less has been the damage to institutional credibility. The RBI is yet to convincingly demonstrate that the demonetization decision was not forced on it. At any rate, it was ill-prepared to deal with the aftermath, in terms of making available adequate quantity of replacement notes in the right denominations.

That re-monetized notes are mostly of the illiquid Rs 2,000 denomination — constituting over 50 percent of the total value of currency in circulation even as late as March 31 — didn’t help matters.

The economic costs — whether manifested in a crash in farm produce prices or wide swathes of cash-dependent informal enterprises going bust, not to mention the sheer time wasted waiting in lines — are incalculable.

In the period immediately after demonetization, there was expectation that it would bring a windfall for the Centre. To the extent that the scrapped Rs 500 and Rs 1,000 denomination notes were not deposited or exchanged at banks — especially by those who had hoarded their ill-gotten wealth significantly in cash — the resultant reduction in the Reserve Bank of India’s (RBI) currency liabilities would generate a “profit”, which it could then distribute as dividend to the government. But this did not happen.

Conclusion

It was a poorly conceived policy with muddled goals that was horrendously implemented. That said, even bad policies can have good, if initially unforeseen, outcomes. The government’s propaganda about demonetization and “digitalization” may be typically breathless. But it’s likely that its actions have forced more Indians to at least become familiar with cash-free methods of payment, with mobile wallets and with digital payments. That can only be a good thing.

It would be good for India, if any future reforms were more productive than the recent ones.