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Demonetisation: India’s stress test

What were the reasons for the Indian government's sudden decision to remove 86% of hard currency from circulation? Will Modi's monetary intervention a

Publishing date
30 January 2017
Suman Bery

There has been extensive global coverage of India’s forced exchange of its high-value currency notes  almost three months ago, referred to locally as ‘demonetisation’. This week the world is again watching India, as the government is about to publish the Union Budget for the fiscal year 2018 (starting 1 April 2017). It is therefore a good moment to assess the goals and impact of the controversial demonetisation over the short- and medium-term

A first observation is that the political fall-out has been remarkably mild. Nevertheless, estimates of GDP growth for the current fiscal year have been reduced by between 0.5% and 1%, largely on account of the disruption to both consumption and production caused by the intervention.

The longer-term benefits (particularly in the form of a radical shift in tax compliance) will depend on follow-up actions, including those that may be announced in the forthcoming Budget. The political impact will be more easily gauged on 11 March when the results of elections in five Indian states are announced, including the most populous, Uttar Pradesh (U.P.)

The announcement

On the night of 8 November 2016, India’s Prime Minister Narendra Modi addressed the nation. He announced that, with effect from midnight the same evening, high-value currency notes in the denomination of Indian rupees (Rs.) 500 and Rs. 1000 would no longer be considered legal tender – except for specified transitional uses designed to avoid hardship. These so-called specified bank notes, or SBNs, would be worth approximately USD7.50 and $15.00 respectively at market exchange rates.  At purchasing power exchange rates, a better measure of real command over domestic goods and services, the equivalents would be nearer $25 and $50.

These specified notes could be deposited into bank accounts or tendered at bank counters in exchange for newly-designed and printed notes in the denominations of Rs. 2000 and Rs. 500.  Anticipating difficulties in immediately issuing such a large number of physical pieces of currency, India’s central bank, the Reserve Bank of India (RBI) simultaneously announced temporary restrictions on the withdrawal of new notes. Some restrictions remain in effect till the time of writing, at the end of January 2017.

The value of specified notes withdrawn has been estimated to account for 86% of the value of all currency in circulation at the time (i.e. ‘currency with the public’, not including vault cash with banks). They had a total value then estimated at Rs. 15.4 tn. (USD226 billion), although this figure is presently being reviewed by the RBI. (The remaining 16% represents lower-value notes which were legally unaffected by the exchange, but whose relative scarcity also became a source of controversy in the weeks that followed.) Total currency with the public has hovered in the range of 12% of GNP in recent years. Press reports have compared this with 18% in Japan and 13% in Switzerland. An estimated 95% of transactions in India are currently settled in physical cash.

In his address the Prime Minister conceded that this drastic action would impose disruption and hardship for a few weeks. He asked for forbearance for fifty days, until the end of December, for these strains to ease. Mr Modi linked this action to a series of measures his government had taken to address the scourge of corruption in India. The premise underlying his speech was that high value currency notes are disproportionately held by those with undeclared and untaxed wealth, often though not always the result of illegal or criminal activity.  Holders of currency held in large amounts and generated through untaxed activities would of necessity expose themselves in the course of conversion, creating an audit trail that would facilitate pursuit by the income-tax authorities.

Following the announcement it has been widely, and correctly, noted that currency forms only one part and perhaps not the most important part, of untaxed wealth, with gold, jewellery and real property (in India and abroad) held by nominees being other popular assets for holding such wealth.  Untaxed wealth can be generated by both legal and illegal activities, and there is (so far) no legal restriction on maintaining large cash balances provided their origin is not illegal activity. Attacking personal holdings of currency is a blunt, broad-spectrum intervention, but as noted below one with considerable symbolic significance.

While ‘black money’ was the dominant strand in Mr Modi’s speech, he also referred to counterfeit currency (allegedly being used to finance terrorist activities) and a move toward digital payments as collateral benefits from this sudden and draconian move.

The assessment that follows is structured into administrative, economic, institutional and political dimensions. The last is undoubtedly the most important if the least knowable at this time.

Administrative issues

There is public consensus on two points: first that the roll-out of the exchange was poorly handled; and that if the aim was to catch the crooks, the crooks seem to have outsmarted the authorities. The public has faced a chronic shortage of fresh high-value notes, indeed all notes, even in the parsimonious amounts that had been promised. The result has been long queues at banks and a fruitless search for cash machines (Automatic Teller Machines-ATMs) actually able to dispense currency.

The problem was compounded by two further factors: an excess supply of the Rs.2000 denomination, which was too large for most transactions given the shortage of lower denomination notes, and the fact that the country’s roughly 200,000 cash machines had to be recalibrated to accommodate the new notes because of the change in their physical size compared with the notes they replaced. A continuing puzzle is why the Rs.1000 note was replaced by a note of even larger denomination if the ostensible purpose was to crack down on illegal activity. One possible explanation is that it was easier to begin planning the introduction of a completely new denomination than to design new imprints of existing notes. This may also be why there was a shortage of Rs.500 notes in the first weeks after the announcement.

While the situation is now better, access to cash remains a sporadic problem even in the large cities. The impact in rural areas, where two-thirds of Indians live and where the density of bank branches and cash machines is much lower than in the cities must have been even more desperate, despite repeated assurances from the authorities that the situation was under control.

The lack of preparedness was also reflected in a steady stream of circulars from the RBI to the banks, altering guidance on how old notes were to be received and handled. These frequent shifts in guidance reflected two deeper difficulties.

The first difficulty was an acute shortage of replacement banknotes in the desired denominations, in the face of capacity constraints at the government-owned presses. There are various hypotheses for this elementary but massive failure in planning, none of which have been admitted to by the government or the RBI. These hypotheses include an unexpected need to advance the date of the exchange because of feared leaks, as also absence of the necessary technical advice in what was by all accounts a very closely-held decision at the highest levels of government. The most recent information attributed to official sources is that Rs. 9.2tn. worth of new notes have been printed since November 8, although there is still lack of clarity on whether these are in all denominations or just replacement high-value notes; also whether this includes vault cash.

The second factor, of greater political significance than the first, has been the almost complete surrender of the specified notes into new notes. Evidence is anecdotal and may be revised as the authorities release more confirmed data. Press commentary at the time of the announcement suggested that many of those with large hoards not willing to accept this additional scrutiny would prefer to destroy their holdings of currency and thereby suffer a one-time loss in wealth, in the process possibly conferring a windfall gain on the government. Popular expectations were that a low surrender ratio would represent losses imposed on high net worth holders of cash; by implication a high surrender ratio implies that holders of illegally generated cash suffered only partial losses on these holdings.

It is widely believed that holders of large currency hoards turned quickly to India’s financial underworld for help. Those intermediaries in turn moved immediately to create trains of human ‘mules’ to break large cash holdings into smaller, less conspicuous amounts to be tendered into their own personal accounts. This process was sufficiently smooth and efficient that the initially large discount on accepting old notes through unofficial channels (around 40% on some accounts) declined substantially as the deadline for official exchange approached.

The near total exchange of specified notes is seen as partially undermining the black money goals of the initiative. It has also been interpreted by some in the press as a possible sign of corruption in the banks, both state-owned and private, with stray reports of bank officials diverting large volumes of new notes to preferred customers. In the main though the banks have done their best to cope with a situation (including largely successful crowd control) for which they had no warning and for which they could not therefore prepare. Overall, on the basis of information available so far, one has to agree with the popular judgement that India’s administrative machine fumbled this major test of its capabilities, thereby denting the Modi government’s claim to competence in execution.

Economic effects

The currency swap took place at a time when prospects seemed to be improving for the economy, with inflation under control and good prospects for agriculture following drought in the two years preceding.

Most international commentators (such as the IMF in its October 2016 World Economic Outlook) were projecting steady growth in GDP of 7.6% in India’s FY17 (April to March) and the same in FY18. This has since been sharply cut back in the WEO January 2017 update to 6.6% and 7.2% respectively, “primarily due to the temporary negative consumption shock induced by cash shortages and payment disruptions associated with the recent currency note withdrawal and exchange initiative” (IMF WEO Update, January 2017). In the same vein the RBI also pared its estimate of real GDP growth for FY17 from 7.6% to 7.1% when announcing its most recent monetary policy update in December.

Any projection at this time can at best be informed speculation. As India’s own Central Statistical Organisation (CSO) noted in putting out its own first Advance Estimate of FY17 GDP (at 7.1%), its methodology of forecasting provides no basis to accommodate a massive ‘black swan’ event such as India has endured. Given the dependence of Indian statistics (as indeed of all countries) on past regularities to fill in for late or missing data, the impact on value-added will only become clear after a considerable lapse of time. In this vacuum one needs to resort both to economic theory and again to fragments reported by the press.

Since this was a large, unanticipated monetary shock, the obvious question is how such a shock affects economic activity. There is little policy importance attached to the split between currency and demand deposits in M1 in rich nations. This is a portfolio decision made by households reflecting their preferences for convenience and privacy, as well as the payments technology prevailing in the country at the time. The banking system is equipped to meet this demand, including any seasonal fluctuations. This was also the case for India until the present disruption; indeed, the note-issue function of the RBI is perhaps one of its least glamorous but most important functions, as impressive in its own smooth reach in normal times as India’s much admired election machinery.

Arguably, if most of the specified bank notes have indeed been converted into deposits (and fresh notes), the shock to available M1 was at best temporary and should reverse itself quite quickly.  The Indian ‘natural experiment’ should in time illuminate the consequences of forcing the non-bank public to alter its currency preference by fiat, but anecdotal evidence suggests that the transitional costs can be quite high. It is also impossible to predict whether currency demand will revert to its previous level or will be structurally lower, with consequent fiscal implications for government revenues from seignorage. This potential loss of seignorage needs to be offset against any improvement in tax compliance as discussed below.

It seems reasonable to assume that currency rationing disproportionately affects output and income in the so-called ‘informal’ sector of the economy. About 45% of gross value added in the Indian economy has been estimated to originate in this sector, defined statistically and behaviourally by its weak linkage with formal financial institutions as also its relative invisibility to direct tax enforcement. (Income from agriculture is in any case exempt from income taxation.) It is this informal economy (which includes agricultural trade, household enterprises and self-employed workers, as well as daily construction labour) that has borne the bulk of the impact through reduced demand for its output. Supply has also been impacted, in agriculture and construction, and more broadly in the supply chain of small and medium businesses serving large-scale manufacturers, who operate in a predominantly cash economy.

These aggregate demand and supply effects remain a poor measure of the real hardship inflicted on the more vulnerable workers in the economy whose lives and livelihoods have been affected by this calamity, no less than for being man-made and policy-induced. To date no official compensation has been offered for this disruption although existing social safety-net programmes (including the nation-wide rural employment guarantee scheme) have been availed of to some degree.

These disruptions though costly would perhaps be justified if they were a necessary price to be paid for propelling the Indian economy onto a higher growth trajectory. The government’s own economists are yet to provide a narrative on the mechanisms by which demonetisation might lead to an increase in long-term potential growth, and will no doubt do so in the forthcoming Budget.

Two routes suggest themselves. The first is if the scale of this shock (as supported by follow-up measures) succeeds in reducing the scale of corruption in the economy. This could In principle reduce the scale of what has been called ‘rent-seeking’ which in turn could result in a boost to the level of total factor productivity (TFP). Even more speculatively, reduced corruption when combined with the other major reform initiative of the Modi government, the introduction of a destination-based federal value-added tax (the goods and services tax-GST), could lead to a sustained period of rising TFP growth as supply chains and indeed factor markets adjust to a business environment where competitiveness matters more than political cover.

The second route to higher potential growth would be via tax buoyancy. For the usual public finance reasons of reduced distortion and greater progressivity, India’s tax establishment has pursued a goal of shifting federal revenues from indirect to direct taxes, a task that became more urgent with the loss of customs duties on account of trade liberalisation twenty-five years ago. While significant efforts have been made to apply information technology to improve administration and compliance, misdeclaration and a sluggish revenue administration machinery have made it difficult to move in the direction of lower rates and fewer exemptions. As with the GST a more efficient (and more productive) direct tax system, linked in turn with reduced ‘informality’ in the small-scale productive sector, would be another route toward increases in levels, and indeed sustained growth in TFP. For his part the Finance Minister has recently noted the importance of tax rates at global levels in fostering India’s deeper integration into global production.

Institutional questions

While this is not the first currency swap that India has attempted, the suddenness and scale of the shock have raised the issue of the powers under which the government imposed hardship by depriving citizens access to their own monetary assets. The issue has reached the Supreme Court of India, which has convened a Constitutional Bench to examine the issue without imposing a stay on the government’s actions. Terms of reference for this bench include whether the government's decision was a violation of the RBI Act and various constitutional provisions; whether its implementation suffers from procedural unreasonableness; and whether curbs on withdrawal of cash from bank accounts have an appropriate legal foundation.

For its part the government has invoked the advice provided it by the Reserve Bank of India.  The Reserve Bank of India Act itself provides that “on recommendation of the RBI’s central board, the government may, by notification in the Gazette of India, declare that with effect from a date specified in the notification, any series of bank notes of any denomination shall cease to be legal tender”. It is another matter that the RBI Board (with numerous vacancies in the ranks of its independent directors) made such a recommendation a few hours before the Prime Minister’s speech and seems to have acted primarily upon the suggestion of the government rather than on its own technical analysis.

The issue of RBI autonomy and credibility could also bear upon the success of its conduct of monetary policy. Led by the present Governor Dr Urjit Patel (in his former role as Deputy Governor) and his predecessor Dr Raghuram Rajan, the Reserve Bank of India had persuaded the Modi government to allow it to move in the direction of formal inflation targeting, with a monetary policy committee appointed as recently as August 2016. There is no evidence that the views of the MPC were sought on demonetisation despite the clear implications for liquidity, economic activity and central bank credibility.

More profoundly, central banks are entrusted with the multiple tasks of inflation control, note-issue and distribution, and exchange-rate management, as complementary tools to uphold faith in the national currency. The preamble to the RBI Act 1934 defines its very purpose as being  ”to regulate the issue of Bank notes and the keeping of reserves with a view to securing monetary stability in India”. Since time immemorial a stable, widely circulating coinage has been seen as the symbol of steadfast state power. It remains to be seen how quickly confidence takes to return, or whether money demand reacts in a more structural fashion to this extraordinary exercise of government powers.

Political impact

Here we reach the heart of the matter. In the two months since the initial announcement Prime Minister Modi has spoken at length to justify the inconvenience and hardship inflicted on the public. In his speeches he has increasingly used the imagery of ‘purification’ of the society. A possible interpretation is that Mr Modi was reminding the public that India was not always the cesspit of corruption and discrimination in favour of the rich that it has become today. For India to join the ranks of serious, modern societies the trio of corruption, informality and tax evasion must be addressed. Demonetisation, for all the technocratic objections to it, is a discontinuity which has been designed to touch the entire population.

The evidence so far is that Mr Modi’s political instincts are correct. At least for the present, the population is willing to give him the benefit of the doubt, as demonstrated through opinion polls, from by-election results, and by the rather muted response of the opposition in the recently concluded winter session of parliament. Through this move Mr Modi has also started a national conversation for reform of political parties and election finance. He has not so far made specific moves in this area, generally seen as the font et origo of the black economy, and the associated wide pathology of criminals in political office in all political parties.

Political considerations also almost certainly explain the timing of the launch of the initiative in November even if planning had started earlier in the year. Elections to India’s states are not synchronised. State Assemblies (as their parliaments are called) have a life of five years unless dissolution is recommended earlier by the state’s Chief Minister. Control of a state Assembly can be of considerable value at the time of general elections, the next one of which must take place by mid-2019. Control of state Assemblies also drives voting rights for the upper house of India’s parliament (the Rajya Sabha or States’ Assembly) in which Mr Modi’s governing coalition (the National Democratic Alliance or NDA) lacks a majority unlike its commanding position in the lower house, the Lok Sabha (People’s Assembly).

It is for all these reasons, as well as a test of his popular standing at the mid-point of his government’s five-year term, that the forthcoming Assembly elections in Uttar Pradesh (U.P.) India’s largest state (estimated population of 215 mn.) assume critical importance. Once an election date is announced (in the case of UP this announcement took place on January 4, as one of five states conducting elections at this time) contesting parties are bound by a strict code of conduct. Actual polling will take place in seven rounds between February and March with results announced on 11 March.  Those results will provide the most definitive political verdict on demonetisation.


Through his speech on 8 November and his various public addresses since then Mr Modi has clearly embraced this initiative as a part of a transformational crusade, with considerable implications for his direct political accountability. Many observers (including the former RBI Governor Dr Rajan, when he was Chief Economist of the IMF) had questioned whether India could ever achieve its full potential through the incremental change characteristic of a constitutional democracy. After two years of relative economic caution, the demonetisation shock represents a decisive break with the past, though not perhaps what economists had in mind. The first and most important judgement will be political and will become evident in a matter of months. Partly dependent on that judgement, and on follow-up actions in the Budget, the full economic consequences will only become evident over the remainder of Mr Modi’s term.

About the authors

  • Suman Bery

    Suman Bery was most recently Shell’s Chief Economist, based in The Hague, The Netherlands. He is currently a Nonresident Fellow of the Brussels think-tank Bruegel, as well as a Senior Fellow of the Mastercard Center for Inclusive Growth. He is based in New Delhi. Suman is currently on leave for public service, as Vice Chair of NITI Aayog.

    Suman had earlier served as Director-General (Chief Executive) of the National Council of Applied Economic Research (NCAER), New Delhi. NCAER is one of India's leading independent non-profit policy research institutions. At various times Suman was a member of the Prime Minister’s Economic Advisory Council, of India’s Statistical Commision and of the Reserve Bank of India’s Technical Advisory Committee on Monetary Policy.

    Prior to NCAER, Mr. Bery was with the World Bank in Washington DC with a particular focus on Latin America and the Caribbean.  At the time of India’s economic reforms (1992-1994), on leave from the World Bank, Mr. Bery worked as Special Consultant to the Reserve Bank of India, Bombay. His professional writing includes contributions on the political economy of reform, financial sector and banking reform and energy trends and policy. He has been a monthly columnist for the Indian business newspaper Business Standard for more than a decade.

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