On 8 November 2016, Narendra Modi, the prime minister of the world’s largest democracy—India—announced that all 500- and 1000-rupee notes, which accounted for 86% of the currency, would be withdrawn from circulation. By making the notes worthless almost overnight, the government hoped to destroy large piles of black money hidden away by tax evaders. In addition, the government claimed the plan would strike a major blow to corruption and counterfeiting and would kick-start India’s transition into a digital, cashless world. These were traditionally untouched topics by political parties in India, often due to the lack of availability of verified data. It was an extremely bold and unprecedented move by Modi and caused a massive economic shock throughout the country. With the announcement, a sense of helplessness and panic struck throughout the country as the money in people’s wallets was made redundant overnight.
People had limited days to get their cash exchanged for the new currency, which was short in supply. The chaos that ensued resulted in several clashes between the bank staff and their customers who demanded the new currency. The poor were the worst affected with no instant access to funds through digital wallets and credit cards. Dozens died in the weeks after demonetization due to financial crises. It has now been two years since the announcement; the dust has settled and we now know the impact that this economic and political gamble has had on India.
Was illegal wealth successfully flushed out?
It was assumed that tax evaders with illegal wealth held outside the formal economy will find it difficult to exchange it for legal tender. However, in August 2018, the Reserve Bank of India (RBI) announced that more than 99% of the old bank notes in circulation prior to the ban had been accounted for; this meant that owners of illegal wealth had successfully found means to convert it to legal tender. The demonetization failed to significantly reduce the RBI’s liabilities; moreover, the new currency printing proved to be an expensive exercise that dented the profits of the RBI and reduced the dividend it paid to the government.
Was the objective of exposing counterfeit currency met?
The new notes issued by the Central Bank had been designed to make them harder to counterfeit; regardless, fake versions of the currency notes were discovered just a few months after demonetization. However, the cases of detection of the fake notes improved due to their proprietary designs.
Is more tax being collected?
Another aim of the demonetization had been to improve India’s poor record on tax collection. The idea was that if more transactions were carried out digitally and in the open, it would be easier to enforce tax payments. The government reported that the note ban had indeed resulted in an improved tax take, largely by revealing more tax evaders. However, the rate of growth in collecting direct taxes had seen a similar increase between 2008-09 and 2010-11, when the Congress party was in power. It is also quite likely that other policies such as an income tax amnesty in 2016 and a new goods and services tax the following year may have contributed as much to the growing tax collection as demonetisation.
Did India become more cashless?
Compared to the long-term trend of the rise in cashless payments, there was a significant jump at the end of 2016, when the notes were withdrawn. Nevertheless, the rate soon reverted to the steady trend rate. The overall increase over time may have less to do with government policy and more to do with changing technology and easier cashless payments. On the other hand, cash in circulation reverted to pre-2016 levels. Not only did cash usage fail to fall, India continues to have a huge informal economy depending almost entirely on cash transactions.
What happened to economic growth?
The abrupt withdrawal of cash from India’s economy, without adequate or timely replenishment, hurt the farming and industrial sectors. Demand for goods and services fell immediately after demonetization. Segments that relied on cash transactions—such as agriculture, organized and unorganized retail, and the micro, small, and medium enterprise (MSME) sector—suffered the most. The Centre for Monitoring Indian Economy (CMIE), a private forecaster, estimated that 1.5 million jobs were lost between January and April 2017 and the labour force participation rate fell from 46.1% to 43.5%. According to CMIE, those between the ages of 15 and 24 years were the most affected, probably because they were relatively new to the workforce and typically held low-skilled, informal jobs paid by cash.
According to the RBI, India’s GDP growth rate slowed from 8% in 2015–16 to 7.1% in 2016–17, and to 6.7% in 2017–18. The Central Statistics Office of the Government reported that during the first quarter of the fiscal year 2018–19 (April to June 2018), India’s GDP registered a growth of 8.2% on the back of a good performance by the manufacturing and farming sectors. However, it might be premature to celebrate this as an indicator that the country is bouncing back to pre-demonetization levels. Tighter financial conditions, high oil prices, and slowing global growth are expected to slow GDP growth again in the second half of this fiscal year. This has led the RBI to forecast GDP growth at 7.4% for 2018–19. Although this is still high compared to global trends, the country’s economic performance would have been better without the dampening effects of demonetization.
Raghuram Rajan, the ex-RBI Governor whose term ended two months before demonetization, said while delivering the second Bhattacharya Lectureship on the Future of India: “The two successive shocks of demonetization and the GST had a serious impact on growth in India. Growth has fallen off interestingly at a time when growth in the global economy has been peaking up”. His comment on demonetization was, that “one cannot in anyway say it has been an economic success”.
What are the political implications for 2019 elections?
The “Middle India” (India’s urban middle-class population), who are socially liberal and economically conservative, were an instrumental part in Modi being elected as the Prime Minister in the 2014 elections. Anti-Congress (the then ruling party) sentiments were at its peak due to two main reasons: a downfall in effective governance and corruption allegations. The Bhartiya Janata Party (BJP) cashed in the scenario and made several ambitious promises. Modi promised a better future for the country and a “new developed India.” The “Middle India” saw him as a messiah of change and development and was voted into the office with absolute majority. The BJP won 282 of 543 seats and the Indian National Congress faced its worst defeat ever in general elections.
If black money had indeed been extinguished in a significant way, it would have established Modi as a champion of the poor and consolidated his party’s hold on the electorate. However, demonetization turned out to be ineffective, and dented Modi’s image as an infallible leader. Although the BJP won assembly elections in 8 of the 12 states that went to the polls in 2017 and 2018, they lost three state elections in a single day in December 2018 which indicate falling confidence. Now, India once again decides who will rule the Parliament for the next 5 years. The general elections are already underway with results expected to be announced on May 23, 2019.
Modi’s opponents claim that he has spent the last 5 years undermining the country’s free institutions, meddling in the Supreme Court’s affairs, intimidating the media, undermining the Central Bank, and encouraging police to look the other way as Hindu mobs target Muslims and other minorities. They point out, with some evidence, that he has failed to create jobs, is ruining India’s reputation as a tolerant country and is favouring some of the country’s wealthiest corporate titans over the poor.
On the other hand, Modi and his supporters point out that he was instrumental in implementing some important and long-delayed reforms, such as a goods and services tax, free medical scheme for the poor and national bankruptcy law. His policies have improved the business climate in India and rocketed the country up the Ease of Doing Business Index 2019 to its highest rank of 77. Modi’s supporters say he needs another term to implement land reform, a national social security scheme, and India’s digitisation. Additionally, since Indian jets crossed into and bombed Pakistan last month, Modi’s support appears to have rallied by means of post-strike nationalist comments.
The past 5 years of Modi’s rule, however, will always be remembered as the time when India made most of its currency worthless through demonetization. In a largely informal economy where the most vulnerable people still have no access to digital payments, demonetization was an ill-considered, draconian measure that did more damage than good to the Indian economy. At the end of two years, the benefits do not seem to have been worth the enormous financial losses and suffering, and we shall soon find out if it will cost Modi a fresh term in the Prime Minister’s office.
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Matthew is a third-year economics and finance student with experience working in sustainability consulting and energy. He enjoys writing about technology, politics and macroeconomics.
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Laukik is a Master of Finance student and a CFA Level 3 candidate. An interest in global economic developments, technological advancements and investment strategies has driven him to pursue a career in asset management. When his head isn’t hidden behind a laptop, he is in the gym doing burpees and mountain climbers!