On November 8, 2016 the Prime Minister of India Narendra Modi announced to the nation that from that point on, two denominations of the Indian currency (the 500 rupee and 1,000 rupee) bills would be invalid or demonetized. They would be accepted only at critical institutions and facilities such as hospitals, pharmacies, and gas stations. These two denominations account for 86 percent of the cash circulated in the economy that has a GDP of $2.30 trillion. The proposed measure to counteract the drop in liquidity was to introduce a new bills of 500 rupees ($8), and 2,000 rupees ($30) which would become the highest denomination in circulation.
The rationale behind this Herculean task was to crackdown on the black money in the shadow economy of India. According to a study conducted by the World Bank in 2010, India’s shadow economy accounts for almost a fifth of its GDP. This is approximated to be below the global average but double that of other rich countries in the world. The government hoped that demonetization would be an effective measure to combat counterfeit notes, and cash being used to fund illicit activities such as terrorism and drug trafficking. An adjunct motive the government had was to push the economy towards a cashless one. It was thought that the cash crunch caused due to this legislation would encourage individuals to adopt cashless transactions using mechanisms such as credit cards and online banking.
Provisions were made by the government for people to deposit cash they had in their homes into their bank accounts until the end of the year. Banks would only notify tax authorities when deposits above Rs 250,000 ($3800) were made. This would aid the tax department in tracing individuals guilty of tax evasion due to hoarding of black money. People were also allowed to exchange their old notes for new ones at bank offices in the country. They could continue to withdraw cash of other denominations at ATMs. However a cap of Rs 10,000 ($150) per day was placed in order to ensure that there was sufficient cash for everybody.
While this sounded like a well thought out plan in theory, it was a calamity in terms of execution. The sheer size of India’s 1.2 billion population hints at why the financial system (banks, government, ATMs) could not bear the demand for cash in the economy. An immense amount of pressure to print new notes was put on the Reserve Bank of India (central bank). Demand for cash had to be satisfied without creating inflationary spirals in the economy. Lines of people were queuing up for cash outside bank offices and ATMs. The ATMs began to run dry, and it would take some time before the new Rs 2,000 denomination was printed and back into full-fledged circulation. Ironically, people who even had Rs 2,000 notes (the new denomination) were unable to use them, as there wasn’t enough change available in the economy to break the large bills. The long hours of waiting in line to get cash wasn’t the end of it. Even when the new notes were printed and ready for circulation, it was realized that the old ATMs were not retrofitted, and were therefore unable to dispense the new denomination.
The socio-economic impacts on the people in the country were massive. To pacify people’s anguish, the charismatic Prime Minister said, “My young friends, you are agents of change who will make India corruption free and ensure more cashless transactions. Together, we must ensure India defeats black money. This will empower the poor, neo-middle class, middle class & benefit future generations," He believed that it was imperative Indians go through pain in the short-run, in order to move to a more efficient, transparent, and corruption-free system in the future.
While the situational reference to the maxim of ‘No pains, no gains’ is understandable, the question of whether the brunt of the ‘pain’ is equally borne by all is debatable. Manmohan Singh, economist and ex-Prime Minister of India, evoked economist John Maynard Keynes during a speech in Parliament in response to demonetization by saying “Everyone is dead in the long run.”
Unfortunately, Keynes’ thinking proved to be true even in the short-run in India. The death toll due to demonetization stands at 90 and counting. This was largely because a large part of the population lives on a daily wage basis. This includes workers of small-scale industries, laborers and unemployed people living in abject poverty. Due to the cash crunch they were unable to sustain themselves and their families. Some were even driven to fatality due to absolute helplessness. In 2012, according to Government sources, 22 percent of India’s population lives beneath its official poverty line. People below the poverty line are dependent on small sums of cash for survival. With 86 percent of the cash in circulation becoming invalid overnight, they would be the worst affected as they are at the bottom of the economy.
Demonetization of notes has been conducted between 3 and 4 times in India’s history. However, passing this legislation in India’s “booming economy is like shooting at the tires of a racing car” according to development economist Jean Dréze. It was a massive blow for businesses involved in using cash based transactions in the short-run. It took time to adapt to the new economic conditions. The stock market took a hit, as investors were unsure of the economic conditions that would follow demonetization. A ripple effect was also felt in the currency market due to a climate of uncertainty in the economy.
It is intriguing to contextualize this economic policy move with regards to Modi’s leadership style of staying constantly relevant and active in the eyes of the Indian people. His approach of extensive international travel, trade agreements and push on executive bills is markedly different from his predecessor who chose to be a more passive influence. The party in power (the Prime Minister’s Party) was also preparing for upcoming state elections when demonetization was announced. Its intent of being a crackdown on corruption neatly fit into the pitch of a government that had a mandate of cleaning up the system in the eyes of the public. The people for whom this pitch would most accurately be placed are the middle-class of the country. Ironically, they may have borne the worst of the administrative and executional anguish of the very same policy.
Everyone gained something from demonetization. The rich population, with whom most of the unaccounted wealth is concentrated, had their wealth secured in property, gold or offshore accounts. It was a knee-jerk adjustment for them to call in their reinforcements to manage the shifting of wealth to not fall under the radar. The government earned a reputation of being an entity that works tirelessly for the transformation of the Indian economy to be a cashless, transparent, corruption-free one. And, the commoner went home with a minimal amount of cash after hours of standing in line with the satisfaction that they were doing their bit to make India a better place.