Demonetisation

On November 8, 2016, two largest denomination notes, Rs 500 and Rs 1000, were ‘demonetized’ with immediate effect, ceasing to be legal tender. At one stroke, 86 percent of the cash in circulation was thereby rendered invalid. These notes were to be deposited in the banks by December 30, 2016, while restrictions were placed on cash withdrawals. In other words, restrictions were placed on the convertibility of domestic money and bank deposits.

The aim of the action, as stated by the government, was fourfold: to curb corruption; counterfeiting; the use of high denomination notes for terrorist activities; and especially the accumulation of ‘black money’, generated by income that has not been declared to the tax authorities.

It followed a series of earlier efforts to curb such illicit activities, including the creation of the Special Investigative Team (SIT) in the 2014 budget; the Black Money and Imposition of Tax Act 2015; Benami Transactions Act 2016; the information exchange agreement with Switzerland; changes in the tax treaties with Mauritius, Cyprus and Singapore; and the Income Disclosure Scheme. Demonetisation was aimed at signalling a regime change, emphasizing the government’s determination to penalize illicit activities and the associated wealth. In effect, the tax on all illicit activities, as well as legal activities that were not disclosed to the tax authorities, was sought to be permanently and punitively increased.

India’s demonetisation is unprecedented in international economic history, in that it combined secrecy and suddenness amidst normal economic and political conditions. All other sudden demonetisations have occurred in the context of hyperinflation, wars, political upheavals, or other extreme circumstances. But the Indian economy had been growing at the fastest clip in the world on the back of stable macroeconomics and an impressive set of reforms (Chapter 1). In such normal circumstances, demonetisations tend to be phased in gradually.

India’s action is not unprecedented in its own economic history: there were two previous instances of demonetisation, in 1946 and 1978, the latter not having any significant effect on cash. But the recent action had large, albeit temporary, currency consequences.

In the wake of the Global Financial Crisis (GFC), advanced economies have used monetary policy to stimulate growth, stretching its use to domains heretofore considered heretical such as negative interest rate policies and ‘helicopter drops’ of money. In fact, India has given a whole new expression to unconventional monetary policy, with the difference that whereas advanced economies have focused on expanding the money supply, India’s demonetisation has reduced it. This policy could be considered a ‘reverse helicopter drop’, or perhaps more accurately a ‘helicopter hoover’.

Analytically, demonetisation should be seen as comprising the following:

• a money supply contraction but only of one type of ‘money’-cash;
• a tax on unaccounted private wealth maintained in the form of cash – black money; and
• a tax on savings outside the formal financial system.
• The scheme included a screening mechanism, aimed separating ‘white’ income from ‘black’. Cash holdings arising from income that had been declared could readily be deposited at banks and ultimately exchanged for new notes. But those with black money faced three difficult choices.

They could:

• declare their unaccounted wealth and pay taxes at a penalty rate;
• continue to hide it, not converting their old notes and thereby suffering a tax rate of 100 percent;
• launder their black money, paying a cost for converting the money into white.

Demonetisation can also be interpreted as a regime shift on the part of the government. It is a demonstration of the state’s resolve to crack down on black money, showing that tax evasion will no longer be tolerated or accepted as an inevitable part of life.

Demonetisation could also aid tax administration in another way, by shifting transactions out of the cash economy and into the formal payments system. With large denominations eliminated, households and firms have begun to shift from cash to electronic payment technologies.

As a result, the tax-GDP ratio, as well as the size of the formal economy, could be permanently higher. Beyond reducing tax evasion, demonetisation will channel savings into the formal financial system. Without doubt, much of the cash that has been deposited in the banking system will be taken out again, as the cash withdrawal limits are eased and the note supply improves. But some of the new deposits will surely remain in the banks, where they will provide a base for banks to provide more loans, at lower interest rates.

In the longer-term, if demonetisation is successful, it will reduce the equilibrium cash-GDP and cash-deposits ratio in the economy. This will increase financial savings which could have a positive impact on long run growth.

Demonetisation is potentially:

An aggregate demand shock, because it reduces the supply of money and affects private wealth (especially of those holding unaccounted money and owning real estate);

• an aggregate supply shock to the extent that cash is
• a necessary input for economic activity (for example, if agricultural producers require cash to pay labour); and
• an uncertainty shock because economic agents face imponderables related to the impact and duration of the liquidity shock as well as further policy responses (causing consumers to defer or reduce discretionary consumption and firms to reconsider investment plans).

CROSS-COUNTRY INSTANCES OF DEMONETISATION

Major Instances of sudden demonetization/sharp currency contractions/changes in the world since 1982 till 2016