At 8pm on November 8th, 2016, in a surprise televised address, Indian Prime Minister Narendra Modi announced to the nation that all Rs 500 and Rs 1000 notes – roughly 86% of the value of all currency in circulation – would cease to be legal tender overnight. They would be replaced with a new series of notes, worth Rs 500 and Rs 2000. Citizens had 50 days to exchange their old notes for these new notes, or to deposit their notes in bank accounts. This unprecedented intervention, called demonetisation, had four main goals: exposing the shadow economy and ‘black money’, curbing the prevalence of counterfeit currency, targeting corruption and terrorism, and increasing digitisation of transactions. However, chaos ensued – new notes could not be printed fast enough, sparking cash shortages in a country that is heavily reliant on a cash-based informal sector. Transactions halted, hindering GDP growth. Serpentine queues formed outside ATMs; numerous instances were reported where bags of currency were simply dumped on roadsides. In the frenzy to exchange old notes, some even died.
Now that demonetisation’s immediate shocks have passed, it is important to evaluate whether the policy was successful, or whether its benefits are minimal compared to its costs. This essay’s approach to answering this question is as follows: first, it will evaluate to what extent demonetisation achieved its four main goals: exposing the shadow economy and ‘black money’, curbing the prevalence of counterfeit currency, targeting corruption and terrorism, and increasing digitisation of transactions. After evaluating these goals, it will assess the unintended consequences of demonetisation. Based on this analysis, it will weigh the policy’s long-term benefits against its costs, concluding that demonetisation was unsuccessful on balance, despite some minor benefits.
The first aim of demonetisation was to expose the shadow economy and ‘black money’. The shadow economy is the informal or underground economy. This is incredibly large in India, estimated to comprise 25-40% of India’ GDP. It includes both legal activities, such as cleaning or gardening, and illegal activities like drug dealing and trafficking. The shadow economy is fuelled by black money – income that is illegally obtained, and/or undeclared for tax purposes. Through demonetisation, the government aimed to tackle the challenges that the shadow economy brought about, such as illegal activity and tax avoidance, by formalising it. In theory, demonetisation would reduce the amount of black money in circulation. If people with excessive amounts of old notes (i.e. black money) wished to exchange this money for new notes or deposit it in banks, they would have to explain their sources – the hope, therefore, was that these people would not exchange these, rendering much of this black money worthless. Exposing the shadow economy would also mean that people working in the informal sector would now have to pay tax. This would widen the tax base, increasing tax revenue that the government could use for community betterment projects, like investment in education or infrastructure. It was also hoped that increasing the amount of tax paid by the informal sector would increase productivity. The formal sector tends to comprise of much higher-productivity industries, made up of trans- national corporations and export-based firms. These firms are highly visible, and generally far less able to avoid tax. Meanwhile, the informal sector is both less productive and more able to avoid tax. In theory, taxing the informal economy at reasonable rates would reduce its overall profitability – this would reduce relative informal returns, encouraging more investment in the higher-productivity formal sector, driving productivity and economic growth.
However, the efficacy of demonetisation in achieving this goal was limited. 99.3% of demonetised currency was returned to banks in subsequent months. Therefore, the government’s argument that demonetisation would flush out large amounts of hoarded black money from the economy did not hold. Therefore, either black money was less prevalent an issue than it was made out to be, or, schemes to launder money were more successful than expected. In many cases, tax cheats could still deposit their large quantities of black money into banks – for example, by depositing through different accounts, or employing other people to deposit money for them. Additionally, even after all demonetised currency had been returned to banks, only around 5% of this was classified as black money. Crucially, note that only around 6% of black money is actually held in cash – most black money is laundered in assets like gold and real estate investments. The government will have been aware of this – so, the idea that demonetisation would come anywhere close to extinguishing black money was a false promise from the start. Despite this, demonetisation was successful in widening the tax base. In 2017-18, roughly 68 million income tax returns were filed, compared to just 46 million in 2015-16. In the financial year 2018-19, corporate tax revenue grew by 14%, while personal income tax revenue grew by 13.3%. Though economic growth played a role in increasing net tax collection, it is likely that demonetisation accelerated this trend, given its sheer scale. Overall, however, demonetisation’s impact on curbing the shadow economy and the prevalence of black money was quite limited.
The second aim of demonetisation was to curb the prevalence of counterfeit currency. S. Gurumurthy, prominent journalist and economic analyst, acclaimed demonetisation in 2016) for its potential to render useless the current counterfeit Rs 500 and 1000 notes that were in widespread circulation. Meanwhile, according to the Reserve Bank of India, the new series of notes post-demonetisation would be harder to counterfeit – the government hoped, therefore, that the overall prevalence of counterfeit notes would fall.
However, the policy had a relatively minor impact in curbing counterfeit currency. The RBI’s own estimate was that fewer than 0.02% of all currency notes in circulation were fake. Detection of fake Rs 50 and Rs 100 notes experienced a three-year high in the financial year ending March 2018 – while there may be multiple factors at play, this suggests that levels of fake currency did not drop substantially post demonetisation. Overall, demonetisation clearly had a minimal impact in tackling the prevalence of counterfeit currency.
The third aim of demonetisation was to target corruption and terrorism. Traditionally, much of the funding for this has been through cash, as the people making these illegal undisclosed transactions cannot go through official means of payment. The hope was that by invalidating much of the cash used to fund these activities, corruption would be tackled, and terrorist groups would be starved of funding. However, there is again little evidence that demonetisation significantly threatened these areas. The problem of corruption in India is far too widespread for demonetisation or any supposed ‘quick fix’ to meaningfully address the problem. Some data suggests that corruption has even increased post demonetisation. According to South Asia Terrorism Portal data, demonetisation also had a very limited impact on terrorism. While there were 905 casualties of terrorism in 2016, there were 812 and 940 casualties in 2017 and 2018 respectively. Although terrorist funding and the number of terrorist deaths are not directly causally linked, and there are multiple factors at play, the fact that the number of terrorist deaths did not fall in subsequent years suggests that demonetisation did not impact terrorism as much as was hoped.
The fourth aim of demonetisation was to increase the digitisation of transactions. The idea was that this would increase the security of transactions, increase convenience for consumers and increase the ease of government oversight. It was hoped that people would be forced to move to more formal digitalised systems of banking and payment in the absence of cash.
In the immediate aftermath of demonetisation, digitisation increased significantly – Paytm, India’s market leader in online banking, experienced a traffic increase of 435%, and a 250% increase in overall transactions and transaction value in the following months. However, though demonetisation catalysed the short-term uptick in digital payments, it did not substantially move India towards a cashless economy. Though the currency to gross domestic product (GDP) ratio fell sharply immediately after demonetisation, it had returned to pre-demonetisation levels by the following year. India is still one of the most cash-dependent emerging economies. This is partially due to the lack of online banking facilities available in the country, as well as informal vendors requesting cash payments to avoid paying tax. A far more concerted effort than the 2016 demonetisation shock will be needed to wean India off its reliance on cash.
In addition to evaluating the success of demonetisation in achieving its intended goals, it is also important to look at the policy’s unintended consequences on the Indian economy and peoples’ lives. In the immediate aftermath of the November 8th announcement, long queues formed outside ATMs. There was a frenzy to deposit old notes in banks and ATMs in exchange for the new series of notes. Over 100 people died in this turmoil. However, the new series of notes could not be printed fast enough to replenish the old ones, sparking a liquidity crisis. The cash shortages in the following months particularly affected the informal sector, in industries such as agriculture, fishing and trucking, where almost all payments are done through cash. Consumer spending and business investment fell. This forced numerous small businesses to close for lack of currency. Though it is impossible to prove that the subsequent decline in economic growth can be fully attributed to demonetisation, it is true that demonetisation had a direct impact on important economic indicators, such as volume of transactions and gross consumer spending, all of which are heavily correlated with GDP growth. It is likely that these effects contributed to the loss of 1.5 million jobs and the fall in GDP growth rate from 7.9% in the first quarter of 2017 to 5.7% in the first quarter of 2018.
In conclusion, when evaluating the effectiveness of demonetisation against its unprecedented economic damage and disruption to everyday life, demonetisation was evidently only successful to a very limited extent. It largely failed to tackle the shadow economy or curb the prevalence of black money. It also had a negligible impact in reducing the circulation of counterfeit currency, and in reducing corruption or terrorist activity. It spurred digitisation in the short term, but with the increase in digital payments has also come an increase in usage of cash – India’s currency to GDP ratio soon reverted to pre-demonetisation levels. Clearly, the only tangible benefit brought about by demonetisation was a widening of the tax base – both the number of taxpayers, and the government’s tax revenue increased noticeably after 2016. However, when weighing this gain against the policy’s costs – civilian deaths and casualties, unemployment and a fall in the rate of economic growth – the policy was clearly unsuccessful despite some minimal benefits.
Perhaps the largest takeaway from India’s demonetisation experiment is not its economic impact or efficacy, but its power as a political tool used by the Modi government. In state elections in Uttar Pradesh in March 2017, which were widely seen as referenda on the demonetisation, Modi’s BJP party won in a landslide. This came despite the policy’s flaws and its failure to deliver on key objectives. However, the policy was not judged by voters on metrics such as currency to GDP ratio, or percentage of demonetised cash returned to banks, or GDP growth rate. Every single citizen was affected by the chaos that erupted. The lay person was willing to tolerate this disruption, as they saw demonetisation as the government’s wholehearted attempt to tackle issues like black money and corruption, perceived existential threats to everyday life. The triumph of narrative and political messages over data and facts is undeniably the most significant outcome of India’s demonetisation episode.
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