India’s Demonetization: What Were They Thinking?


April 2017 | By: By John E. Marthinsen

Estimated reading time: Estimated reading time: 12.5 minutes

Key Takeaways


  1. If India’s goal is to increase its income tax base by digitizing transactions, then the November 2016 demonetization will not be enough. Further incentives must be found that drive residents away from cash transactions and toward electronic payment systems—systems that are increasingly more convenient, easy to use, simple to understand, and able to reach even the most remote, unbanked parts of the country. In the long term, thought should be given to the costs and benefits of a state-approved, nonanonymous digital fiat currency (i.e., mobile money), such as Ecuador has done.
  2. If India’s goal is to reduce the wealth that individuals have accumulated from their underground transactions, then focus needs to be shifted from the 6% to 10% held in cash and refocused on uncovering the 90% to 94% held in other assets, such as precious metals, jewelry, and real estate.
  3. If India’s goal is to increase growth and development, then additional incentives should be put into increasing returns to its highly productive formal sectors relative to its low-productivity informal sectors.


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On November 8, 2016, India’s prime minister, Narendra Modi, made a surprise evening television appearance to announce that, starting at midnight, the nation’s 500-rupee and 1,000-rupee (i.e., ₹500 and ₹1,000) currency notes would no longer be legal tender. Merchants immediately refused to accept them, and residents were given until December 30 (i.e., 50 days later) to deposit their old, invalid notes or convert them. Coincident with the elimination of the ₹500 and ₹1,000 notes was the issuance of new ₹500 and ₹2,000 notes. Modi’s announcement sent shock waves through the nation, and for good reason: The old ₹500 and ₹1,000 currency notes made up slightly more than 86% of India’s total currency in circulation; more than 90% of the nation’s financial transactions were conducted in cash; more than 85% of India’s workers were paid in cash, and, finally, about 50% of the nation’s population were unbanked—they didn’t have even the most basic checking account. On one side, the International Monetary Fund and many knowledgeable analysts praised the move as a major step to reduce underground activity, while other, equally respected and knowledgeable analysts, including Nobel Laureate Amartya Sen and former prime minister Manmohan Singh, considered demonetization to be unfair and riddled with potential problems.

What Is Demonetization?

Demonetization occurs when a government removes a currency’s legal tender status, which means the money is no longer officially recognized as a medium of exchange for meeting financial obligations or settling debts. Typically, old notes are retired and replaced with new ones. In cases where the intent is to stop corruption, demonetization usually targets only large-denomination banknotes. By contrast, if the intent is to cut zeros from existing price levels, introduce policies that dramatically reduce hyperinflation rates, and/or restore public confidence in the monetary system, a government may demonetize by introducing a totally new or renamed currency, as did Germany (1923), Argentina (1983, 1985, and 1992), Brazil (1986, 1990, 1993, and 1994), and Zimbabwe (2010).

Why Did India Demonetize?

India suffers from a large informal (underground) economy, which is estimated at 25% to 40% of the nation’s GDP. Individuals working informally pay little or no taxes because their incomes are unreported. Regardless of whether the underground activities are legal (cleaning, gardening, or selling groceries) or illegal (unlawful drug dealing, gambling, terrorism, arms trafficking, corruption, or money laundering), they enable tax avoidance, evasion, and fraud, which reduces government revenues. As a result, community betterment projects, such as infrastructure repairs and improvements, may go unfunded, and for those projects that are funded, underground tax evaders are able to freeload off the nation’s taxpayer base. This fact helps to explain why initial reactions by India’s taxpayers were often ones of pride because the government seemed to be striking openly at those who flaunted their wealth without paying nearly their share of taxes.

Stopping or slowing the growth of India’s illegal underground activities was a desired goal because they undermine the nation’s moral fabric, but as a matter of social fairness, the government’s intent was broader, aiming to expose both the legal and illegal layers of its informal economy. Currently, fewer than 4% (and perhaps as low as 1%) of India’s population pays taxes. By making the ₹500 and ₹1,000 notes illegal, Modi hoped that India’s thriving informal economy might be forced into the light. Individuals who exchanged excessive amounts of old notes would be required to explain their sources. Old currency notes that were held beyond the deadline would lose their value, and those who continued to use, transfer, receive, or even hold the old banknotes would be subject to fines of either ₹10,000 or five times the value of the banknotes. By promoting the use of checks, credit cards, and other forms of electronic payments, demonetization might make underground transactions more difficult to hide. And, if demonetization was able to broaden the nation’s tax base and increase government revenues, it held the potential to reduce Indian tax rates, which could increase domestic investments and spur meaningful growth.

Demonetization also tackled an economic distortion that currently favors India’s low-productivity, informal sector. High-productivity sectors, such as those in which multinational firms and export-oriented domestic companies compete, are visible and, therefore, less able to escape taxes. By bringing the informal economy above ground and taxing it at reasonable rates, demonetization could bring symmetry to India’s tax-based incentive structure. As a result, relative underground returns should fall, supplying more capital to relatively high-productivity sectors and, thereby, stimulating the nation’s growth and development.

Digitizing India’s transactions also might increase the supply of credit and lower interest rates. Currently, a huge swath of India’s population has little or no access to the nation’s institutional credit markets. As a result, a significant amount of financial capital is locked outside formal financial networks. If demonetization improves electronic payment systems and encourages residents to use India’s financial intermediaries, it could unlock this potential by supplying funds for domestic investments.

India’s demonetization is just one important part of a much broader plan to reduce corruption, digitize the economy, and improve the nation’s infrastructure. In 1988, 2011, and 2016, the government addressed corruption by passing and then twice revising the Benami Transactions (Prohibition) Act, which focused on transactions between fictitiously named individuals. In August 2014, the Prime Minister’s People Money Scheme (Pradhan Mantri Jan Dhan Yojana) was initiated to increase the population’s use of financial services. In October 2014, Prime Minister Modi launched hisClean India Campaign (Swachh Bharat Abhiyan) to change the nation’s sanitation culture and public health infrastructure. On June 1, 2016, India passed the Income Declaration Scheme, which gave citizens until the end of September 2016 to declare their black-money earnings and wealth, pay taxes and penalties on them, and, thereby, avoid future prosecution. In 2016, India passed its Goods and Services Tax Act, which will consolidate most central and state taxes into a system of indirect taxation on the manufacture, sale, and consumption of goods and services. It is expected to become effective by mid- to late 2017. Finally, beginning later in 2017, India will start exchanging information with foreign nations in which Indian citizens are believed to have parked their black money earnings. India’s newest government budget, which was released on February 1, 2017, reaffirms the nation’s commitment to fight black market activity and digitize the economy.

How Did India Demonetize Its Currency?

The idea was simple: Holders of old ₹500 and ₹1,000 Mahatma Gandhi Series notes could go to any bank and either redeem them for new Mahatma Gandhi Series notes worth ₹500 and ₹2,000, or they could deposit these funds into existing or newly created bank accounts. But, demonetization was inefficiently implemented, due largely to the fact that preparations were shrouded in secrecy to avoid notifying underground operators and to prevent them from covering their tracks.

Problems were numerous and disproportionately borne by those without access to credit cards or formal financial intermediation services. Time was lost waiting in long lines at banks to exchange old notes for new, and resentment grew with knowledge that many of those in line were being paid (e.g., fees of 25%) to exchange old notes for the rich. Those who were most patient believed that Modi’s long-term goal was just, but others were impatient and angry, feeling their time and wealth were being expropriated by the government. Protests broke out and many lawsuits were filed, some of which made their way to India’s Supreme Court.

Demonetization caused severe shortages of cash because insufficient amounts of new notes had been printed and distributed. Banks ran out of bills, automatic teller machines (ATMs) broke, and those that functioned were quickly exhausted because replenishment rates were inadequate. Liquidity also was reduced because the new rupee notes were smaller than the old ones, and not enough ATMs had been retrofitted. Adding to the pain were government-imposed limitations (daily and weekly) on the amounts individuals could exchange for new notes, or withdraw from bank accounts and ATMs.

The resulting cash shortage particularly affected agricultural, fishing, trucking, and underground sectors, where virtually all payments are made in cash. Farmers found they couldn’t purchase seed, fertilizer, and pesticides for their crops. Many small businesses closed for lack of currency, and numerous shops were either unable or unwilling to give change for the new ₹2,000 notes. As a result, shoppers were forced either to walk away from purchases or to buy something worth, say, ₹600 but pay ₹2,000.

A final piece of the demonetization plan was set on December 28, 2016, when the government passed its Specified Banks Notes (Cessation of Liabilities) Ordinance, thereby eliminating the Reserve Bank of India’s liability for these defunct notes.

Were there exceptions?

There were exceptions to the new rules. For limited periods after the deadline, old notes could be used at hospitals, crematoria, compressed natural gas and petrol stations, railways, airlines, state-run dairies and ration stores, as well as for municipal and local tax payments. Not surprisingly, there was a huge spike in delinquent tax payments. Indian residents who were out of the country during the 50-day exchange period were given until March 31, 2017, to exchange their old notes for new ones, and nonresident Indians (NRI) were given until June 30, 2017, to do the same.

What Were the Consequences of Demonetization?

The short-run and long-run consequences of demonetization will, most likely, be quite different.

Short-run consequences

The short-run effects of demonetization were predictable but also conflicting. Fears caused gold prices to spike and stock indices (e.g., the BSE SENEX and NIFTY 50 indices) to plummet, and resulting cash shortages caused consumer spending (especially for high-priced items) and business investment to fall. At the same time, deposits increased, which gave banks greater lending ability, and interest rates fell, which should have encouraged business investment. In the push and pull of economic forces, the negative ones seemed to win, resulting in analysts predicting (in February 2017) a decline in the coming year’s real GDP growth rate by one-half percent, equivalent to approximately $8.5 billion.

Long-run consequences of demonetization

The long-run effects of demonetization are uncertain.

Will demonetization reduce India’s underground economy?

Two facts throw into doubt the extent to which demonetization penalized India’s black money assets. First, less than 10% (perhaps, as low as 6%) of Indian residents’ unreported wealth is estimated to be held in cash. The rest is in assets, such as gold, jewelry, and real estate. Second, by the end of December 2016, about 97% of India’s old ₹500 and ₹1,000 notes had been exchanged and/or deposited in banks, far exceeding government expectations. Of course, individuals who were marooned with nonexchangeable counterfeit bills were harmed—as intended.

Nevertheless, it is helpful to keep in mind that wealth is a stock concept, which means it reflects net worth at a point in time. By contrast, how individuals obtain their black wealth is a flow concept because these funds were received on a day-by-day basis. If Indians maintain their extreme preference for cash transactions, flow-type gains will be transitory and small, which is why transaction digitization will be a major key to unlocking long-term gains.

In an effort to promote cashless payments, a new section (269ST) of India’s Income-Tax Act was proposed in the government’s 2017–2018 budget, which would prohibit individuals from using cash when their single-day, single-transaction amounts exceed ₹300,000. Harsh penalties, amounting to 100% of the payment, would be applied to those who did not use checks, bank drafts, or other electronic banking alternatives.

Will demonetization stimulate e-commerce in India?

One promising result of demonetization has been a dramatic increase in top line sales for India’s e-commerce and digital payments companies. Credit card usage, point-of-sale activities, and electronic payment services, such as those offered by Paytm, PayuMoney, Freecharge, and MobiKwik, have grown and should continue to grow. As long as demonetization does not drive residents toward cryptocurrencies, such as bitcoin and Ethereum’s ethers, it should improve the government’s ability to track incomes.


November 8, 2016 was not India’s first experiment with demonetization. It did the same in 1946 and 1978, with the intent to reduce black market activities. This fact is worth remembering because it provides a reality check on optimistic expectations that this time might be different. Only time will tell if India’s demonetization will be anything more than a one-time inconvenience. Finance Manager Arun Jaitley’s 2017–2018 budget speech, on February 1, 2017, signaled both good and bad news. The good news was that between November 8 and December 30, 2016, deposits ranging from ₹200,000 to ₹8,000,000 (i.e., $3,000 to $120,000) were made into 10.9 million bank accounts, and deposits exceeding ₹8,000,000 were made into 148,000 accounts. The bad news was, for a population of 1.25 billion people, this activity amounted to a mere 1% drop in the bucket.

When the exchange process is finally completed in June 2017, demonetization should have little or no long-term effect on India’s official money supply because it simply replaces old ₹500 and ₹1,000 notes with new ₹500 and ₹2,000 ones and leaves it to the central bank to adjust the total money supply to its desired level. In the end, India’s demonetization will be a success only if it:

  • Creates economic opportunity for more of the population by financially enabling them with better and more available banking and electronic payment services
  • Convinces Indian residents to gradually change their spending habits from cash to digitized transactions, thereby making them safer and less expensive, while improving the government’s ability to track transactions, fairly tax income, and make social welfare payments
  • Increases the government’s tax base, thereby reducing budget deficits and providing needed revenues for infrastructure improvements
  • Slows the creation of black money by bringing the underground economy into the daylight
  • Reduces terrorism

Proof that real reform has taken place will be how the government reinforces demonetization with meaningful tax reform and enforcement, as well as how successful its efforts are to reduce incentives for capital to flow toward offshore tax havens.