Banknote Folly: India’s Wild Demonetization Scheme

On November 8, 2016, Prime Minister Narendra Modi shocked the world and greatly altered the daily lives of his fellow countrymen when he declared that India’s 500 and 1,000 rupee banknotes, the largest in circulation, would be banned. Affecting over a billion people, the decision has been the most extensive anti-corruption demonetization effort in world history. While this endeavor had noble intentions, the result has been mass chaos. For hundreds of millions of Indians, it has been an inconvenience at best; for many, it has ruined lives.

In order to combat corruption, the 500 and 1,000 rupee bills that were in circulation (worth approximately $7.50 and $15, respectively) were banned. The production of 1,000 rupee notes was discontinued, while the 500 rupee notes were replaced by new ones that are harder to forge. Additionally, the government introduced a new 2,000 rupee bill. It is also purportedly more difficult to counterfeit than past bills.

To keep the impending demonetization change a secret from individuals and groups within the black market, few new 500 and 2,000 rupee banknotes were produced before November 8. Moreover, the process of exchanging old notes for new ones was made purposefully burdensome. Only 4,500 rupees were allowed to be exchanged per day, and people attempting to exchange large quantities had to explain how they accumulated such reserves through licit means.

“Affecting over a billion people, the decision has been the most extensive anti-corruption demonetization effort in world history.”

Effectively hindering the use of large notes for corruption purposes could  have had enormously salutary effects in India. Currently, corrupt individuals and organizations operating in cash-only enterprises choose not to declare income to the government. Because they are unbanked and digitally nonexistent, the income of corrupt entities is easier to conceal. The physical accumulation of these notes enables tax evasion, thereby depriving the most vulnerable Indian citizens of much needed government-provided resources.

In addition, dark money in cash form advances racketeering prospects, especially since hard-to-trace cash can be more easily funneled into criminal and terrorist networks. Finally, the disruption unfolding in India’s cash economy has prompted millions to switch to digital banking services. Transferring India from a physical currency economy to a digital one would do much to modernize the economy, encourage foreign direct investment, and spur growth.

Unfortunately, the actual consequences of the government’s actions were far from beneficial. Rather, they continue to reverberate negatively throughout India. After November 8, a cash shortage ensued. The endless lines at banks (both in the cities and in rural areas) were reminiscent of times when governments imposed capital controls to stem financial crises. Yet, the crisis in India was self-inflicted.

Writing in The New York Times, Kaushik Basu, former chief economic advisor to the Indian government and former chief economist at the World Bank, claimed “demonetization was ostensibly implemented to combat corruption, terrorism financing and inflation. But it was poorly designed, with scant attention paid to the laws of the market, and it is likely to fail. So far its effects have been disastrous for the middle- and lower-middle classes, as well as the poor.”

The lucky were merely inconvenienced. The unlucky, who are primarily poor, had their business operations curtailed. Either they could not pay their employees or they themselves were not paid. Any person without access to digital credit or debit found it extremely arduous to make large payments for legal and legitimate purposes. The economic ripple effects undoubtedly caused joblessness and hunger.

“Any person without access to digital credit or debit found it extremely arduous to make large payments for legal and legitimate purposes. The economic ripple effects undoubtedly caused joblessness and hunger.”

Among the unlucky was a young man interviewed by The New York Times. His name is Yashpal Singh Rathore. In the wake of the November 8 policy, his upcoming wedding was delayed. Because of the cash shortage, the parents of his fiancée lacked the liquidity to pay the wedding services. Later, because of a cash shortage-induced demand slump at the motorcycle company for which he worked, his job was axed. Subsequently, his prospective in-laws delayed the wedding again until he finds a job. “So I lost my job and I lost my marriage,” Mr. Rathore told The New York Times while protesting with fellow fired employees of Hero MotoCorp Ltd.

There were very good reasons to remove these large bills from circulation. For example, Larry Summers, the former treasury secretary  under Clinton and director of the National Economic Council  under Obama, has used some of the very same reasoning espoused in India to repeatedly put forth a call for the discontinuation of the 100 dollar bill in the United States and the 500 euro bill in Europe. Yet, the execution of the program in India was so wanting and its effects so destructive that even he came out against it.

In The Washington Post in late November, he wrote “actions like those taken by the ECB or those proposed for the United States end the creation of new high-denomination notes. They do not contemplate declaring what has been legal tender to no longer be legal tender essentially overnight. It is the imminent prospect of notes currently held becoming worthless that has created such alarm and disruption in India.” Mr. Summers added, “small and medium-size merchants have seen their shops (which transact mostly in cash) deserted, and ordinary Indian citizens have spent the past week in line outside banks hoping to exchange their cash holdings for legal tender.”

Furthermore, it is not clear that the very rich corrupt Indian individuals who were supposed to be impaired by the currency change were adversely impacted. It is conceivable that these people, rather than keeping their ill-gotten gains in suitcases filled with 1,000 rupee notes, simply have their wealth stored in gold, precious metals, foreign currency in foreign banks, or some combination of the three. Finally, because the Modi government decided to accompany its actions with the introduction of a 2,000 rupee banknote, it is not certain the Indian economy will not in a matter of years be in the same position it was prior to November 8.

Notwithstanding this significant stumble, the Indian economy is growing and modernizing rapidly. After the folly of this scheme became apparent, the IMF shaved but a point off of India’s projected GDP growth, which fell from an estimated 7.6 percent to a still robust 6.6 percent. And just as the United States during the Gilded Age was rife with corruption and unsavory business practices, so too is India today. Nevertheless, with the correct set of anti-corruption laws and the fostering of a strong anti-corruption societal ethos, there is no reason India cannot create a world-class functioning 21st century economy.

Image: 100 Indian National Rupees. (Sudipto Sarkar, Flickr, Creative Commons)


Marco F. Moratilla works for New Magellan Venture Partners, LLC, a venture capital firm. He has experience at the National Security Archive and the U.S. House of Representatives. He holds an M.A. in international affairs from The George Washington University and a B.A. in political science from the University of California, San Diego. His work has appeared in International Affairs Review. A native Californian, he spent his formative years in Madrid, Spain.

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