The Demonetization Move

In a sudden and unprecedented move, on November 8, 2016, the Indian Government banned/ demonetized its ₹500 & ₹1,000 currency notes. This resulted in 86% of the country’s in-circulation currency (equivalent to approx. $225 Bn) to cease being a legal tender in an economy which is 90% cash-reliant. The old notes are to be replaced by new ₹500 and ₹2,000 notes by December 30, 2016. Some exceptions were eventually allowed including gas stations, hospitals, airlines/ railway booking counters etc.

Objectives

The main motivation behind this abrupt move was to:

  1. Take a hit on corruption, smuggling, drugs etc. by exposing black, illegal and counterfeit money
  2. Encourage digitization through replacement of cash transactions with digital payments

Negative impact

The abrupt demonetization has not been without its negative consequences including:

  • Since the plan was kept very secret (reportedly shared only among the Prime Minister and his 5-6 very close aides who worked from the PM’s home), banks were not prepared to cope with the massive scale of cash deposits or withdrawals.
  • Capacities to print new currency also could not match with the huge demand resulting in large queues, riots, public unrest and even deaths of many people. Caps on Individual cash withdrawals, therefore, had to be imposed which kept on varying as per the cash demand-supply position.
  • Small businesses and salaried individuals were the hardest-hit as their salaries remained unpaid and transactions.
  • Indian stock markets crashed to 6-months low resulting in wiping out billions of dollars’ worth of investments.
  • Country’s growth rate estimate has been reduced by 0.5% per annum just because of this step by almost all global observers.

Loopholes

There were also a number of loopholes in the demonetization implementation including:

  1. Illicit undeclared cash was used to purchase gold.
  2. There have been attempts to use old cash for donations, tax payments, railway bookings etc. where old notes were allowed.
  3. Back-dated accounting and using multiple bank accounts and transactions were also modes used by people to circumvent the imposed restrictions.

Were Objectives Met?

As far as the first objective of checking black money is concerned, there hasn’t been much success since as per reports, 82% of the banned currency notes with a value of approx. $182 Mn had already been deposited in bank accounts and declared to be earned through legitimate means. So to avoid embarrassment, Indian Government’s focus has now completely shifted to Objective No. 2.

Although, there has been a major surge in digital payments and to an extent, use of crypto currencies such as ‘Bitcoin’ on a smaller scale since the demonetization drive has started, there have been a broad range of structural impediments which will make the transition to cashless environment difficult:

  • Indians have a cash-reliant economy which is substantiated by its ‘Cash in circulation to deposit’ and ‘Cash in circulation to GDP’ parameters which stand at 51% and 12.04% respectively, much higher than their peers.
  • The country does not have a strong payments and digital infrastructure with only a small fraction of population having bank accounts, knowhow of digital payments, using mobile payments etc. So it would have been wiser to strengthen the digital payments ecosystem first and then introduce the demonetization initiative.

The entire global community is closely watching the outcome of India’s demonetization experiment which will take at least a few more months to be revealed, however, so far it seems like a poorly-implemented and not a very well thought out venture which has negatively impacted the Indian economy at least in the short run.

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