Demonetizing India: Good Intentions, But Poorly Implemented

Image via theindianeconomist.com

Going all digital in a cash-based society of 1.3 billion people wasn’t going to be easy, but some preparation would have helped.

On November 8th, 2016, India’s prime minister Narendra Modi announced that all 500 and 1000 rupee banknotes would be invalid past midnight. This removal of 86% of all currency in circulation overnight was called “demonetization,” a tame term for what was effectively an economic shock.

The move caused India (an economy where more than 90% of transactions are cash-based) to grind to a standstill for weeks, and resulted in polarized debate on the topic for months. As a result, it is no surprise that the motives for this controversial program have been under close scrutiny.

Heralded as a crucial step toward curbing black money, reducing corruption, and combating counterfeiting, demonetization was publicized by the Indian government as an apparent silver bullet for India’s shadow economy.

But as an economic strategy, did it fit its purpose?

In the six months leading up to the announcement, the Modi government managed to print vast sums of new banknotes in complete secrecy. As a result, individuals and organizations in possession of large amounts of black money did not receive advance warning, and were unable to launder their cash in time. The introduction of the new 500 and 2000 rupee notes eliminated the old counterfeit currency in one fell swoop.  At least, those were the statements that were repeatedly used to justify the program.

Upon closer inspection, however, the efficacy of the move is questionable.

In the days following the decision, crowds sieged banks that were grossly understaffed. Queues at ATMs snaked down streets and alleys, and the machines themselves lacked sufficient cash to keep up with demand. Furthermore, almost 50% of the population lacked bank accounts to exchange their old notes. In comparison, only 7% of American households are unbanked.

Furthermore, demonetization was intended to eliminate significant amounts of black money by preventing individuals from depositing their illicitly-obtained cash (as this would entail scrutiny by the authorities). However, banks were estimated to have received 97% of the currency demonetized. This means that virtually all of the demonetized currency was accounted for, contrary to expectations that hordes of black money bearers would be left with piles of outdated currency that they would be unable to deposit.

This could mean one of two things: either black money is a non-issue in the Indian economy, and demonetization was wholly unnecessary, or illicit funds were exchanged with no repercussions due to the same corrupt behavior demonetization was intended to combat. The latter is far more likely.

Hence, while those targeted by demonetization managed to find ways to turn their black money into legitimate rupees, it was ultimately the masses who suffered. The Indian lower income groups lacked debit and credit cards prior to demonetization, and transacted solely in cash. The inability to conduct such transactions was expected to seriously impair productivity (reflected in the 6.4% projected GDP growth rate) and to cause general dissatisfaction.

However, GDP growth figures have curiously remained at over 7%. It will be intriguing to see whether this figure holds up for the rest of the year, as the current value does not capture the impact on small enterprises and unorganized workers, i.e., the two groups hardest hit by the decision.

Moreover, instead of feeling general dissatisfaction, the population buoyed Modi’s Bharatiya Janta Party to a victory in the election for India’s largest state. The public rallied behind Modi, viewing tolerance of demonetization as their own contribution to the fight against corruption. However, given growing concerns that black money has not been reduced as significantly as expected, Modi may quickly fall out of favor if public sentiment shifts.

In light of these blows to Modi’s “surgical strike on corruption,” the official narrative evolved as well. While originally intended to fight black money, demonetization quickly became a push to make the Indian economy less cash-reliant. Indeed, digital payment platforms saw huge increases in the number of transactions conducted in the immediate aftermath of demonetization. The issue with the lack of bank accounts resolved itself, as the economy saw a vast number of bank accounts set up in the following four weeks. In fact, the greater number bank accounts caused a significant growth in the tax base, with the government seeing a rise in indirect tax revenues in the aftermath of demonetization. These positive externalities of the move were proudly displayed as intended benefits rather than happy coincidences.

So is India’s example a model for other countries troubled by the scourge of the shadow economy? No. Nevertheless, India’s experiment is an important lesson. With “No Cash” signs still visible on ATMs nearly six months later, India has demonstrated that governments will need to weigh the consequences carefully before resorting to such a drastic example of shock doctrine economics.

As India’s experiment is not the first ever instance of mass demonetization, there are numerous opportunities to learn by example. Take the European Union in 2002, when twelve member nations replaced their respective currencies with the Euro in a single, seamless transition.

While the context of the move was different entirely, there are important lessons to be learned from Europe. The EU began printing currency for its changeover more than two years in advance, and began supplying banks with new notes almost three months before the deadline. India, on the other hand, began planning its move a mere six months before the actual date. Furthermore, Indian commercial banks were informed of the drastic decision on the day of the actual announcement, and only had a matter of days to prepare for the panicking public.

The European Union is a quintessential example of effective demonetization for the right purpose. The EU’s goal of creating a common currency did not require strict confidentiality, meaning people were aware of the move well in advance, and adequate time was taken to prepare the necessary infrastructure to prevent chaos.

On the other hand, the Indian government’s aim of eradicating corruption (and the speed and secrecy this entailed) meant that the use of demonetization as an economic strategy did not consider the three things most vital for its success: its purpose, the preparation, and the people.

Parthav Shergill lives in Bangalore, India and writes about Indian politics and economics.

 

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