Cash & Investment Management

India Demonetisation Q1 2017

Friday 3rd March 2017

On the night of 8 November 2016, India’s Prime Minister Narendra Modi addressed the nation in an unscheduled live televised address to the nation at 8.00pm, and announced that, with effect from midnight the same evening, high-value currency notes in the denomination of Indian 500 rupees and 1000 rupees would no longer be considered legal tender, except for specified transitional uses designed to avoid hardship. These specified bank notes, or SBNs, would be worth approximately $7.50 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.

After Modi’s announcement, the Governor of the Reserve Bank, Urjit Patel and Economic Affairs secretary, Shaktikanta Das explained in a press conference that one purpose of the action was to fight terrorism funded by counterfeit notes. While the supply of notes of all denominations had increased by 40% between 2011 and 2016, the 500 rupee and 1,000 rupee banknotes increased by 76% and 109%, respectively, owing to forgery. They said that forged cash was used to fund terrorist activities against India and that the demonetisation had a counter-terrorism purpose.

In June, the Government of India had devised the Income Declaration Scheme that lasted till 30 September 2016, providing an opportunity to citizens holding black money and undeclared assets to avoid litigation and come clean by declaring their assets, paying the tax on them and a penalty of 45% thereafter.

Patel also informed that the decision had been made about six months ago, and the printing of new banknotes of denomination 500 rupee and 2,000 rupee had already started. However, only the top members of the government, security agencies and the central bank were aware of the move. But media had reported in October 2016 about the introduction of 2,000 rupee denomination well before the official announcement by RBI. This statement led to much debate, because the Reserve Bank governor six months before the announcement was Raghuram Rajan, while the new banknotes have the signature of the newly appointed governor, Urjit Patel.

These SBN’s could be deposited into bank accounts or tendered at bank counters in exchange for newly-designed and printed notes in the denominations of 2000 rupees and 500 rupees. Anticipating difficulties in immediately issuing such a large number of physical pieces of currency, India’s central bank, the Reserve Bank of India simultaneously announced temporary restrictions on the withdrawal of new notes.

The value of specified notes withdrawn has been estimated to account for 86% of the value of all currency in circulation at the time. They had a total value then estimated at 15.4 trillion rupees, 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.

The BSE SENSEX and NIFTY 50 stock indices dropped 6% on the very next day after the announcement. In the days following the demonetisation, the country faced severe cash shortages with severe detrimental effects across the economy. People seeking to exchange their bank notes had to stand in lengthy queues, and several deaths were linked to the inconveniences caused due to the rush to exchange cash.

Initially, the move received support from several bankers as well as from some international commentators. It was heavily criticised by members of the opposition parties, leading to debates in both houses of parliament and triggering organised protests against the government in several places across India. The move is considered to have reduced the country’s GDP and industrial production. As the cash shortages grew in the weeks following the move, the demonetisation was heavily criticised by prominent economists and by world media.

The Indian government had demonetised bank notes on two prior occasions, once in 1946 and then again in 1978, and in both cases, the goal was to combat tax evasion by “black money” held outside the formal economic system. In 1946, the pre-independence government hoped demonetisation would penalise Indian businesses that were concealing the fortunes amassed supplying the Allies in World War II. In 1978, the Janata Party coalition government demonetised banknotes of 1000, 5000 and 10,000 rupees, again in the hopes of curbing counterfeit money and black money.

In 2012, the Central Board of Direct Taxes had recommended against demonetisation, saying in a report that “demonetisation may not be a solution for tackling black money or economy, which is largely held in the form of benami properties, bullion and jewellery.” According to data from income tax probes, black money holders kept only 6% or less of their wealth as cash, suggesting that targeting this cash would not be a successful strategy.

On 28 October 2016 the total banknotes in circulation in India was 17.77 trillion rupees. In terms of value, the annual report of Reserve Bank of India of 31 March 2016 stated that total bank notes in circulation valued to 16.42 trillion rupees of which nearly 86% (around 14.18 trillion rupees) were 500 rupee and 1,000 rupee banknotes. In terms of volume, the report stated that 24% (around 22.03 billion) of the total 90266 million banknotes were in circulation.

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.