On the evening of November 8, Prime Minister Narenda Modi of India went on an unscheduled live television address to the nation and declared that the circulation of all Rs 500 (USD 7.50) and Rs 1000 (USD 15) banknotes of the Mahatma Gandhi Series will stop being legal tender as of midnight, a mere four hours from his announcement. In exchange for the old banknotes, the government will issue new Rs 500 and Rs 2000 banknotes of the New Mahatma Gandhi Series. The banknote denominations of Rs 100, Rs 50, Rs 20, Rs 10 and Rs 5 of the Mahatma Gandhi Series continue to remain as legal tender. ATMs all over India were closed for two days and banks for one day to work out new banknote exchange mechanisms. Indians were told they could deposit or change their old notes with the banks until December 30.
Until the end of December, people will only be allowed to withdraw Rs 4500 maximum per day from ATMs or banks, and Rs 24000 per week in maximum withdrawals from banks. Any exchange amount more than the daily withdrawal limit must be deposited in banks and the tax authority will be alerted to any deposit of more than Rs 250,000. The depositor will be asked to justify the existence of such a huge cash deposits in his account and will pay the appropriate penalty if found to be guilty of tax evasion. Online transactions have been granted an exemption from such limits. The unexpected demonetization move follows the end of a four-month amnesty for tax evaders who declared USD 9.8 billion of previously undisclosed assets and paid a penalty of 45 percent.
Rationale behind the Demonetization
Prime Minister Modi explained that the demonetization was done in an effort to stop the counterfeiting of the current banknotes, as these had allegedly been used for funding terrorism. The demonetization was also designed to crack down on black money. Black money is a term used in India which refers to income illegally obtained or undeclared for tax purposes. The demonetization of the Rs 500 and Rs 1000 banknotes was designed to throw hoarders of black money off by rendering their cash money worthless, and they now have to get the notes exchanged at a bank and run the risk of official investigations into their cash hoarding. There are 16.5 billion pieces of Rs 500 and 6.7 billion pieces of Rs 1000 banknotes in circulation based on official data, and these demonetized notes account for 86 percent of all banknotes (Rs 18 trillion or USD 265 billion) in circulation (see Figure 1). The initial estimate of the government indicates that Rs 3 trillion (USD 44 billion) will not be exchanged. Though the figure is a preliminary estimate with a large margin of error, the non-exchanged amount represents a windfall to the government and acts as a one-time tax on black money and a possible disincentive for future black money accumulation under the prospect of future demonetization.
Figure 1. India's banknotes in circulation
This is not the first time that India has demonetarized black money. In 1978, the country scrapped then-truly high value notes — denominations of Rs 1000 (USD 34.50), Rs 5000 (USD 172.5), and Rs 10,000 (USD 345). These demonetized notes accounted for only 2 percent of the country’s then-entire cash supply, significantly less than the more than 85% today. The impact on the economy was generally muted in 1978.
Indians are poor tax payers, less than 2 percent of the population or 5.5 percent of Indian wage earners pay income tax. Nearly 85 percent of the economy is outside the tax net. The move to demonetize the banknotes appear to force many businesses to start using banks or digital payments, so their income can be monitored. India’s tax to GDP ratio is just 16.6 percent, considerably lower than global peer countries average of 22% (see Figure 2).
Figure 2. Tax revenue as percentage of GDP
Source: Ministry of Finance, India
Initial Confusion, Political Backlash, and Collateral Damages
India is a typical developing economy heavily dependent on cash for economic transaction. More than 80 percent of consumer transactions are in cash. Circulating cash M0 is 14 percent of GDP, compared with less than 5 percent in other large economies. The abrupt demonetization of so much banknotes in circulation has hampered many consumer transactions. Markets around the country are deserted as everyone are queuing outside the banks and ATMs to exchange their old banknotes. The situation is further compounded by the logistical bottlenecks that have impeded distribution of the new currency. A poignant incident is the new Rs 2000 banknote is slightly smaller in size than the old ones and the 200,000 ATM machines across the country need replacement parts to handle the new notes.
The initial confusion forced Prime Minister Modi to defend his unexpected decision on November 14. “I know the forces against me,” Modi said. “They may not let me live. They may ruin me because their loot of 70 years is in trouble.” His 97 years old mother unexpectedly showed up at a bank to exchange her money; she obligingly filled the mandatory form, put her thumbmark on the form and exchanged for money (see Figure 3). The gesture is apparently targeting ordinary Indians with a subtle message that the mother of the prime minister is following the law and suffering alongside the ordinary folks. It is reported that as many as 30 poor Indians committed suicide in the initial week of banknote exchange because of the stress and fear associated with the exchange.
Figure 3. Modi's mother goes to bank to exchange notes
Few people will argue that the rural poor in remote locations are being inadvertently hurt the most. These folks normally hold higher denomination banknotes as savings and they may not get the news in time to deposit or exchange notes by the end of the year. Another hard-hit sector are the poor outside the formal banking system; they are typically illiterate and are now being forced to pay touts to fill out forms to exchange their old banknotes. They are estimated 300 million illiterates in India.
Bold Experiment or Reckless Adventure?
Demonetization was usually done in countries facing hyperinflation problem as an intermediate step prior to the launching of new currency. Large scale overnight demonetization and currency replacement have only occurred in countries undergoing government or economic collapse. The demonetization disruption has never occurred in countries with stable economic condition. In fact, the generally stable global inflationary picture since the 1990s and a better understanding of people’s economic behavior has made the demonetization attempt a policy tool of last resort. The economics of demonetization is complex and often the collateral damage will far outstrip the benefits. What Prime Minister Modi did on November 8 is a novel shock therapy experiment in controlling black money. While many observers applauded his determination, its success is questionable.
The benefits of demonetization are limited; the flushing of black money out of the system is a one-time event and the return of black money will be inevitable. In fact, a new type of black market has emerged on how to change old currency notes into new ones. There are reports of a surge in demand for luxury goods and gold after Modi’s sudden announcement as wealthy Indians rushed to make luxury purchases with unaccounted black money. One luxury watch outlet in north-west Mumbai saw 45 Rolex watches sold in one day; the business is what the shop usually did in one month. The same happened in gold; the price shot up to Rs 52,000 per 10 grams after the demonetization announcement, double that of the previous day.
The initial logistic malaise in the implementation of the banknote exchange shows that India does not possess the infrastructure setup required in a large scale financial sector overhaul. More than half of all Indians still don’t have a bank account, and some 300 million still don’t get government identification papers. The vast rural heartland stores don’t have access to card-payment systems. Once the December demonetization exercise is completed, the country will fall back to cash-based transaction with the same opportunity for cash-based black money.
There is good news in the demonetization exercise; the influx of almost USD 45 billion deposit to the banking system in the first five days of demonetization allowed the banking system to lower the interest rate by 0.15 percent. The estimated “black money tax” of more than USD 40 billion can give government coffers a meaningful boost. Of course, the increasing digitization of money after the demonetization exercise will hopefully cut down black money down the road.
There is little doubt that Modi’s bold shock therapy will yield good long-term result to the economy if the short-term shock can be properly minimized and manage. The contrasting fortune of Soviet Union and China in the 1980s when one embarked on shock therapy type of reform while the other fashion its reform on creeping pace to allow the institutional catch-up is a good historical reference case. The real issue of shock therapy is not so much on the rationale behind it, but it is whether the prevailing institution can support such a rapid change and ensure its success. The advantage of a calibrated reform agenda is that it allows institutional support to build-up and support whatever reform down the road. Of course, the calibrated reform runs the risk of waning political support when time drags on. Whether the reform enthusiasm of Prime Minister Modi can energize the bureaucracy is something that observers should closely watch.
The success of the current demonetization rest on the ability of Indian bureaucrats on minimizing the economic repercussion of a sudden disappearance of liquidity in certain parts of the economy in which black money concentrates. In the case of India today, almost the entire consumer sector unfortunately belongs to this category. The slow-down we see if proven temporary, the demonetization effort can be declared as successful. Many observers remarked, “If it is just a two-week glitch, it is not a disaster and good for the long-term. But if it’s a two-month glitch, then it could be bad.”