Demonetisation Decoded

A Critique of India's Currency Experiment

Jayati Ghosh, C. P. Chandrasekhar, Prabhat Patnaik

• Publisher: Routledge India
• Year: 2017
• ISBN:
  9781351664011
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

On the night of 8 November 2016, at 8: 15 pm, India's Prime Minister, Narendra Modi, announced in a televised broadcast to the nation that with effect from midnight, currency notes of denominations Rs 500 and Rs 1, 000 would no longer be legal tender. In one stroke, this involved the de-recognition of over 86 per cent of the value of Indian currency in circulation with only four hours' notice.

This important book provides a quick and concise explanation of the goals, implications, initial effects and the political economy of this major demonetisation move by the Government of India. It clarifies key concepts and offers astute economic analysis to guide the reader through the various claims, arguments and critiques that have been made; highlights the complexities of the processes that have been unleashed; and examines the likely outcomes in the long term as well as those that are immediately evident.

Timely and lucid, this book will interest students and researchers in the fields of economics, finance, management, law, politics and governance as well as policy makers, legislators, civil society activists and the media.

1 Introduction

This book examines one of the most extreme monetary experiments in recent history to have occurred anywhere in the world – the demonetisation of supposedly ‘high-value’ notes in India on 8 November 2016. This move, ostensibly directed towards the elimination of ‘black money’ and corruption, did not have the intended results. However, it had massive effects in terms of immediate distress, disruption of the economy and time and incomes lost by working people. In the months immediately following its announcement, the demonetisation measure raised many concerns relating to its legality, its rationale and its fallout. This book attempts to probe these issues to assess what its impact has been on different sections of the population.

In this introductory chapter, we explain what demonetisation is, summarise the main features of this particular move in India and discuss how the stated goals of the initiative have changed over time. We also provide a brief summary of experiences of demonetisation in other countries. In the next chapter, we consider the arguments made for demonetisation and consider the extent to which they are valid, as well as the logical fallacies involved in several of the arguments. In Chapter 3, we examine how the scheme worked until 31 December 2016, assessing the extent to which it met some of the stated goals and the many problems that resulted from both the design and the chaotic way in which it was implemented. The fourth chapter contains a discussion of the immediate effects of the demonetisation on a range of sectors and activities. The macroeconomic effects as well as the implications for banking are considered in Chapter 5. In the sixth chapter, we take up the more recent declared goal of creating a ‘cashless’ or ‘less-cash’ economy. Finally, Chapter 7 concludes with a brief discussion on the political economy of this demonetisation along with a consideration of the ways in which the problems of black money and corruption could be more effectively addressed in India.

What is demonetisation?

Most non-credit money in the world today is what is called ‘fiat money’; that is to say, it is not backed by any real commodity such as gold, but is only backed by the legal power invested in the issuing authority by the government. Currency, in the form of bank notes, is therefore ‘legal tender’ whereby the issuing authority (usually the central bank, in India’s case the Reserve Bank of India, RBI) promises to accept that note at its face value. Demonetisation is the removal of that backing – it is the process by which particular currency notes are no longer legal tender.

But all currency notes are promissory notes, explicitly or implicitly backed by the state. They contain the words ‘I promise to pay the bearer the sum of __’. So demonetisation can never simply abandon that promise – it must involve the exchange of all such notes into money of equal value, either in the form of some other, newer notes or some other form of liquidity that is acceptable in that economy. The question of whether that exchange must be immediate or can be relatively long drawn out is a thorny one, on which there is no clear legal opinion. But what is abundantly clear is that no central bank – or the government that owns it – can simply renege on its commitment to accept the value of the demonetised note eventually, unless it makes explicit changes to the law. It can create conditions that may limit the voluntary exchange of such notes, such as the threat of penalties or taxation on notes brought in for exchange that prove the existence of undeclared income. But it cannot simply refuse to accept them without providing in return something of equal value. If the government adopts legal routes (such as an Ordinance or law that ‘extinguishes’ these notes) to deny this promise, to the extent that this has a significant impact on holders of such notes, this does risk destroying the trust that is the entire basis for fiat money in a modern economy.

The impact of the demonetisation, in terms of its own objectives as well as other collateral effects, will depend upon the role played by the currency notes that are withdrawn in the total money in circulation as well as the speed and efficiency with which replacement notes are made available to the economy concerned, so that it does not suffer loss of liquidity for exchange for too long.

The demonetisation announcement of November 2016

On the night of 8 November 2016, at 8.15 pm, Prime Minister Narendra Modi announced in a televised broadcast to the nation that at the stroke of midnight, currency notes of denomination Rs 500 and Rs 1,000 would no longer be legal tender. He declared that ‘black money’ would be sucked out of the system and trashed; that those earning black incomes, holding black wealth and involved in counterfeiting currency would be pursued and incarcerated for ruining the economy and oppressing India’s poor; and that the flow of counterfeit notes from across the border that fed domestic terrorism would be stopped. Using the analogy of a previous secret military operation, politicians and the media began describing the policy as a ‘surgical strike’ on the black economy.

At one stroke this involved the de-recognition of slightly more than 86 per cent of the value of currency in circulation, with only four hours’ notice. Banks were declared closed for the following two days to prepare for the new situation. People were allowed time until 30 December 2016 to give in the demonetised notes at offices of the RBI or commercial banks, to be credited into their bank accounts. Old notes were also permitted to be exchanged ‘for immediate cash needs’ over the counter up to a limited amount (first Rs 4,000, then increased to Rs 4,500 and later reduced to Rs 2,000 per day and subsequently stopped altogether) with a valid ID proof and on filling up a form. This was meant to be a once-only exchange, and for some time permanent ink marks were made on those engaging in such exchange to prevent repeated transactions.

The exceptions made for the use of the demonetised notes appeared to be relatively limited. Petrol, CNG and gas stations; government hospitals; railway and airline booking counters; state government-recognised dairies and ration stores; and crematoria were allowed to accept the old Rs 500 and Rs 1,000 bank notes until 11 November 2016, a deadline that was later extended first to 14 November, then 24 November and finally 15 December (but restricted to 2 December for petrol and gas payments). Religious bodies, including trusts run by spiritual leaders, were also exempted, in that they were allowed to receive donations in the old notes. However, cooperative banks and other financial institutions were not allowed to exchange old notes.

Deposits of the demonetised notes into banks were allowed only until 30 December 2016. At first it was stated that the RBI would continue to accept such notes until 31 March 2017. Subsequently, an Ordinance was promulgated (Specified Bank Notes (Cessation of Liabilities) Ordinance, 2016 to come into force from 31 December 2016). This legally terminated RBI’s liability on the banned currency notes, and even prescribed a penalty (Rs 10,000 or five times the amount seized) for anyone found to be holding more than ten such notes or dealing in these notes. It allowed for exchange of notes at the RBI for a few months more, but only for Non-Resident Indians and those who could show that they had been out of the country over the period between 10 November and 30 December 2016. The purpose of the Ordinance (which would have to be later ratified by Parliament) was to prevent future litigation – but even so, it was not clear why penalties for holding the banned notes were required, since they had anyway been rendered useless.

Cash withdrawals from bank accounts were restricted to Rs 10,000 per day and Rs 20,000 (later Rs 24,000) per week. ATM withdrawals of cash were limited to Rs 2,000 per day, and then to Rs 2,500 per day by end-November. Foreign tourists were only allowed to exchange foreign currency up to Rs 5,000 per person per week. Originally, it was expected that the limits on cash withdrawals from the banks would also operate only until 30 December. However, the slow rate of printing and making available new notes and the resulting shortage of replacement currency notes meant that withdrawal limits continued to operate well after this date, and indeed continued even three months into the exercise. Therefore, liquidity constraints continued to be felt not only in the informal sector but in the entire economy.

These were severe measures at best, considering how dependent the Indian economy and population are on cash transactions. India is a heavily cash-dependent economy, in which more than 95 per cent of all transactions were estimated to be in cash when this move was announced. Informal activities where cash transactions are the norm account for around half of national income and around 85 per cent of all workers, and even the formal sector is heavily dependent upon cash payments. So this move impacted directly and indirectly not just on people’s ‘convenience’ but on all economic activity. Further, the requirement of depositing money into bank accounts became a significant barrier for those who did not have bank accounts, who still constitute a significant proportion of the population, who were in effect forced to rely on the black market to change their old notes.

The shifting goalposts of India’s current demonetisation

The shock announcement of Prime Minister Modi on 8 November, which he described as ‘a movement for purifying our country’, had the explicit aims of dealing with ‘the problem of terrorism and the challenge posed by corruption and black money’. Obviously, these goals are laudable in themselves, and very few people would oppose them: the debate really hinges on the best means to achieve these goals, in a way that does not cause damage to innocent people and the society at large. The stated perception was that this move was designed to punish ‘antisocial and antinational elements’ (presumably those guilty of corruption and tax evasion, as well as those engaged in terrorist activities, often using counterfeit money) since their undisclosed currency holdings would become ‘just worthless piece of paper’. In the process, as the prime minister reiterated on several occasions subsequently, the guilty would go through sleepless nights, while the innocent would sleep soundly. So the early focus was entirely on rooting out corruption, essentially by wiping out the value of cash hoards, and curbing terror financing that had been based on counterfeit notes. In his televised speech to the nation on 8 November 2016 that announced this move, Mr Modi used the phrase ‘black money’ 18 times, and also mentioned the other goal as the elimination of terrorism. It was this hortatory device that was also used to mobilise and convince ordinary people of the soundness and desirability of this move. Temporary sacrifices were seen to be necessary in this ‘war on corruption’. People standing in queues were repeatedly compared to soldiers at the frontlines of combat, thereby reducing the serious travails faced by citizens to minor inconveniences that could be borne happily as part of a major national movement to cleanse Indian society of corruption.

Subsequently, as the amount of deposits of cash into the banking system grew well beyond the government’s own expectations, the failure of this move to eliminate cash hoards stored by ‘black marketeers’ became clear. This led to a remarkable display of shifting policy motivations, at least as per the declarations of the prime minister and other government spokespersons and the RBI, which was the unfortunate entity charged with its implementation. So the goalposts were changed: first to a greater focus on containing the problem of counterfeit notes, then to enable the dramatic growth of bank credit, then to a process of formalising the economy by forcing all the cash into bank accounts so as to allow more tax collection and finally to the move towards a ‘cashless society’.

As early as mid-November 2016, the RBI shifted its official stance to focus on the problem of counterfeit notes and the need to eliminate them. In its revised ‘Frequently Asked Questions about Demonetisation’ on its website (www.rbi.org.in), it mentioned corruption only once and almost in passing as the reason for the demonetisation. Instead, it devoted a lot of space to the proliferation of counterfeit notes, their use by terrorists and the need to flush these out of the system. The fact that this did not require any kind of abrupt and sudden decision, but could easily and effectively have been done in a gradual manner without disrupting the economy and people’s lives, was ignored.

By late November, as it became evident that neither of these goals of flushing out ‘black money’ or striking against terrorism was likely to be met by this move, the policy focus shifted again, this time towards moving to ‘a cashless economy’. Cashlessness was defined as the virtue that would propel the Indian economy to a new level of modernity and glory, and even if a completely cashless economy was unattainable, a ‘least cash’ economy was made the important goal of this exercise. The prime minister’s ‘Mann ki Baat’ radio broadcast of 27 November 2016 sang the glories of digitised transactions and exhorted all Indians, especially the young, to embrace this new mode of payment and convince others to do so as well. Once again, it is obvious that even if this were the goal, this is something that could be better done gradually, by encouraging and enabling Indians to rely more on digital and electronic transactions, by providing better infrastructure and connectivity so that people would choose to use less cash for their own convenience.

Meanwhile the Finance Minister and the Revenue Secretary opted for a more philosophical approach to the unexpectedly large inflows of demonetised currency that were being deposited in the banking system. By early December 2016, it was being stated that this was apparently what they had wanted all along, because it brought transparency into the system and forced people to reveal all their holdings, so that they could now be investigated. So the goalpost was shifted once again, this time simply to one of allowing the tax authorities to investigate cases that looked suspicious. This too completely begged the question of why this could not have resulted from a more gradual implementation over several months, which would still have forced the money into banks while allowing ordinary law-abiding citizens to continue to use the old currency until adequate replacement currency was provided. This would have avoided the hardship, loss of employment and fall in livelihood inflicted upon hundreds of millions of people and enabled the tax administration to proceed on its own to identify wrong-doers.

In his address to the nation on 31 December 2016, on reaching the self-declared fifty-day deadline after which the pain of demonetisation was supposed to end, Prime Minister Modi had yet another justification for the move. ‘Over the last ten to twelve years, 500 and 1,000 rupee currency notes were used less for legitimate transactions, and more for a parallel economy. The excess of cash was fuelling inflation and black-marketing. Lack of cash causes difficulty, but excess of cash is even more troublesome.’ This unsubstantiated claim effectively suggested that most of the people transacting in cash are somehow engaged in ‘illegitimate’ transactions, rather than simply operating in an informal economy with incomes that would anyway fall below the direct tax threshold, or using cash for perfectly legitimate purposes in the formal economy. It assumed that informal activities are not part of the ‘mainstream’ economy, whereas there are strong linkages and constant interaction between formal and informal sectors in India. This argument also betrays a lack of understanding of the nature of inflation, as we discuss in Chapter 2.

It is now evident that those who conceived of and implemented this extraordinary measure were unclear about its essential goals, and what yardstick of success or failure they could use. Meanwhile the massive collateral damage inflicted upon innocent people continued to be officially interpreted as a minor ‘inconvenience’ that was a necessary part of this supposed nation-building exercise.

Other experiences of demonetisation

In other countries, demonetisation of a proportion of a country’s currency – typically higher value notes – has usually been suggested either to prevent their use in criminal activities or to reduce the possibility of unrecorded transactions that escape the tax net. Very rarely (and only in a few extreme cases noted below) has demonetisation had the explicit intent of destroying the store of value of those who have such illegal or unrecorded incomes. This is because it is generally recognised that the returns from such activities are mostly not retained in the form of cash.

More recently, arguments for demonetisation in developed countries have been made by Kenneth Rogoff¹ and Joseph Stiglitz² in terms of moving away from currency-based transactions to cashless electronic transactions. They argue (interestingly, from completely diverging analytical frameworks) that in advanced economies, purely electronic-based systems would allow for more effective monetary policy. Rogoff believes that this would enable prolonged imposition of negative interest rates, which he (wrongly) believes is the only way to lift the advanced economies out of stagnation. This argument can be critiqued on several grounds. It ignores the effect of fiscal policy on macroeconomic activity and therefore places excessive reliance on monetary policy alone. It ignores the effect of negative interest rates on asset bubbles that generate financial volatility. But most of all, it is based on a wrong presumption: negative interest rates cannot be sustained simply by eliminating cash, that is doing away with the monetary liability of the central bank, for in such a world another liquidity substitute, another asset which is not the monetary liability of the central bank (such as gold) will emerge to ensure that the interest rate does not fall below zero. In effect, an equilibrium where free asset choice prevails is inco...