India’s Demonetization: Explained
Why the world’s sixth largest economy is shedding some of its currency
In the United States, 40% of transactions involve cash. That’s a larger share of economic activity than debit cards (25%) and credit cards (17%), yet hardly indispensible.
Now imagine an economy, not quite as large but still massive, in which cash is used in 90% of transactions. Further, in this economy, 86% of the cash in circulation exists in the form of two banknotes, the 500 (roughly $7.5 USD) and 1000 (roughly $15 USD) bills.
Now imagine the government abruptly announces these two notes will no longer be valid, will no longer be considered legal tender, moving forward.
Welcome to India’s demonetization.
November 8, the most momentous day of this past year, saw Donald Trump spectacularly defeat Hillary Clinton to become the next President of the United States. On that same day, India’s Prime Minister, Narendra Modi, gave a surprise address in which he announced the demonetization of the 500 and 1000 rupee notes.
In the speech, Modi announced the creation of a new 500 and 2000 rupee notes. These new bills went into effect on November 10.
Modi’s announcement sent shockwaves throughout the country and parts of the world.
Given that the bills stripped of their legal tender status are so prominent within the Indian economy, how did the Indian government expect the people in possession of these bills to manage this news?
The people were given a set of protocols to follow in order to exchange their demonetized notes for the new ones (or the old 100 rupee note, which is still valid).
The Reserve Bank of India (RBI) announced that Indian citizens can go to any RBI location or any bank branch and trade in their demonetized bills for credit into their accounts. The deadline for doing so is tomorrow, December 30, effectively giving them less than two months total.
What about cash on hand needs? Recall that 86% of the cash in circulation exists in the form of 500-rupee and 1000-rupee notes — the very ones demonetized on November 8.
The RBI specified two ways by which Indians could trade their old bills for new ones. They could go to a bank and, with valid ID, fill out a form to secure the exchange. They could also withdraw money from their accounts in the form of valid bills. The RBI put in place limits for both of these mechanisms, limits that it has had to continually adjust in light of economic disruptions.
So far, quite predictably, Modi’s scheme has destabilized many aspects of the Indian economy.
Wade Shepard, writing for Forbes, describes the impact of demonetization thus far:
Modi’s demonetization initiative caused a sudden breakdown in India’s commercial ecosystem. Trade across all facets of the economy was disrupted, and cash-centric sectors like agriculture, fishing, and the voluminous informal market were virtually shutdown, with many businesses and livelihoods going under completely — not to mention the economic impact of millions of people standing in line for hours to exchange or deposit canceled banknotes rather than working or doing business.
India has done this before, of course. But the India of 1946 and even 1978 cannot be compared to the economic behemoth it is today. According to data from the IMF and World Bank, India is projected to be the sixth largest economy in 2017, up one place from seventh, in 2016. It is the second largest emerging market, after China.
So, then, why has the government done this?
In his address, Modi cited multiple justifications, including (a) eliminating black money; (b) reducing the prevalence of counterfeit currency, which is allegedly used to fund terrorism against India itself; and (c) curbing corruption and criminal activity of various kinds that have been faciliated by the 500-rupee and 1000-rupee banknotes.
The first justification is seen as the big one. The eminent Indian economist Kaushik Basu put out an op-ed in The New York Times explaining India’s vulnerability on this front:
India has a large amount of what is known as “black money,” meaning cash or any other form of wealth that has evaded taxation. According to a 2010 World Bank estimate, the most reliable available, the shadow economy in India makes up one-fifth of the country’s G.D.P. (A 2013 study by McKinsey, the consulting firm, puts the figure at more than one-quarter.)
Black money tends to exacerbate inequality because the biggest evasions occur at the top of the income spectrum. It also deprives the government of money to spend on infrastructure and public services like health care and education. According to the World Bank’s most recent estimate, from 2012, India’s tax-to-G.D.P. ratio is about 11 percent, compared with about 14 percent for Brazil, about 26 percent for South Africa and about 35 percent for Denmark.
Modi’s approach will certainly eliminate some of this black money. But it won’t be able to grapple with the black money held in the form of precious metals and other assets, such as real estate holdings. As Basu notes: “the bulk of black money in India isn’t money at all.”
Other notable economists have offered criticisms of their own.
Amartya Sen, the Nobel-winning Harvard economist, has said that “only an authoritarian government can calmly cause such misery to the people.” Sen’s point in calling Modi’s government “authoritarian” is that it is an authoritarian move to eliminate the trust embedded in the protection of currency stability. The people expect the government to protect their bills, not to destroy them.
The New York Times columnist Paul Krugman, also a Nobel winner, has said of India’s demonetization strategy that it “seems like a one-off attempt to flush out illicit cash.” While he understands why the government would want to pursue this policy, he characterizes the move as “highly disruptive.”
Perhaps sounding a more optimistic note than many other critics, Krugman further writes:
I would be happy to be proven wrong. There could be some permanent change in behaviour.
He did add that it will likely result in people being “more careful and sophisticated in laundering their money in the future.”
Not all reactions have been negative. Columbia professor Jagdish Bhagwati calls Modi’s gambit “a courageous and substantive economic reform that, despite the significant transition costs, has the potential to generate large future benefits.”
Narendra Modi will be up for reelection in 2019. Obviously, he’s hoping his demonetization strategy will produce long-term benefits for India. But he will also need it to show signs of life in the shorter term.
That’s…going to be hard to do.
Mashable has a write-up of the toll demonetization has taken on ordinary Indians:
Nearly three dozen people have died in the aftermath of India’s bold, surprising move…. Some of these people have reportedly died standing in the long snaking queues, while many others died because hospitals, pharmacy shops, and ambulances refused to offer services in exchange of old notes.
A child reportedly died at a hospital owned by union culture and tourism minister Mahesh Sharma, after the staff refused to accept old notes for treatment….
There have been reports of people dying after standing in queues for hours to exchange their old currency notes. A 72-year-old man named Karthikeyan was pronounced dead Friday when he was brought to a hospital in Alappuzha district in the southern India state of Kerala. The man reportedly stood in front of State Bank of Travancore branch for hours.
The Mashable report is sobering. Writing in The Wall Street Journal, American Enterprise Institute’s Sadanand Dhume puts the issue into focus:
Perhaps the optimists will be proved right, but at this point their gauzy hopes of future benefits must be weighed against the present pain. Even if demonetization ends up producing some gains, the question of whether it was worth its considerable costs will linger. Moreover, the simple fact that no credible expert suggested such a drastic policy before Mr. Modi announced it makes many arguments in its support look like belated apologia.
Two and a half years ago, based on his record as the business-friendly chief minister of Gujarat, Mr. Modi stormed to national power as India’s great economic hope. At least for now, the demonetization debacle has shaken this assumption to its foundations.
There’s no denying India is going through a lot these days. Whether it will all be worth it remains to be seen.
