CHAPTER 7

History of Demonetization in India

Demonetization was perhaps the biggest step in the Indian economic history. As of now, demonetization of currency notes in India has taken place on three occasions: January 1946, January 1978, and November 2016. This chapter is devoted to the discussion on the demonetization of 1946 and 1978. The next chapter will analyze the recent demonetization of November 2016. The advent of the currency dates back to the Indus Valley Civilization. Kingdoms issued royal seals, that is, coins made of gold, silver, and copper, that kept changing with the rulers and the dynasties. The rupee is named after the silver coin, rupiya, first issued by Sultan Sher Shah Suri in the 16th century and later continued by the Mughal Empire. In 1735, Nadir Shah devalued currency, which led to a surge in inflation, withdrawing his decision subsequently (Rastogi 2016). The RBI has the mandate under the RBI Act of 1934 to regulate the issuing of banknotes in India.

The Concept of Demonetization

Across the globe, the legitimacy of a nation’s currency is an outcome of a solemn promise by the head of the issuing authority. Conceptually and technically, therefore, all money is fiat money. It is as good as its promise to pay and is honored either by the country’s central bank or by the government, which issues the currency notes. Demonetization is an act of divesting a currency unit of its status as legal tender, in some cases, replacing it with new currency units, which can be characterized as remonetization, in which forms of payment are restored as legal tender. It is the process where the government declares the currently running currency notes illegal. When there is a change in national currency, the old unit of currency is replaced with a new currency. Demonetization is the act of changing the existing currency to another form. It is important to remember that the confiscation of money is not the objective of the government’s demonetization exercise.

First Demonetization (January 1946)

Successive governments in India carried out demonetization for a variety of reasons. In 1946, the background was World War II, during which businessmen in India made huge fortunes while supplying the Allied war effort and were concealing their profits from the tax department. According to RBI data, 1,000 and 10,000 banknotes were in circulation prior to January 1946. After that, the government demonetized 1,000 and higher denomination banknotes. The preindependence government of India passed the High Denomination Banknotes (Demonetization) Ordinance. The government promulgated two ordinances on Saturday, January 12, 1946, which was declared a bank holiday. The first ordinance asked the banks to furnish information about the currency holdings of various denominations (100, 500, 1,000, and 10,000). The second was about telling the public that the denomination currency notes of 1,000 and above were demonetized; the 100 banknote was spared.

The currency notes of 1,000 and 10,000 were removed from circulation, and people were given little time for exchange. As the notes were accounted only to 3 percent of India’s population, it did not affect people’s normal life to some extent. People were given 10 days for exchange, which meant the first helpline ended on January 23. This was later extended to February 9, when people had to explain why they could not exchange their currency in the first 10 days. Thus, a time limit was fixed for the exchange of demonetized notes by genuine holders at the RBI, or its agencies, on the basis of their declaration. Their declaration and explanations regarding the source of earnings, etc. were investigated carefully. The exchange was not permitted if the explanation of the source of income was not satisfactory. This caused great difficulty to people.

There seems to be some similarity in the reactions from the public, indicating that there is something cyclical about demonetization. The secrecy with which the current government pulled it off has parallels in 1946. “Never was a secret so well kept in Delhi,” wrote the Times of India (ToI) on January 26, 1946. Even the government officials were left with high-value notes to hand in. The ToI wrote that only eight officials knew about the plan, including the RBI governor and the finance member of the Viceroy’s Council (the equivalent of today’s finance minister). In order to be issued on Saturday, January 12, the ordinance had to be flown in a special plane from Delhi to Poona for the viceroy’s signatures. It was then flown back. During the discussions with the RBI Governor Chintaman Deshmukh (later to be Jawaharlal Nehru’s finance minister), the officers took notes and typed drafts themselves, without the help of any secretary. “The handwritten notes exchanged between these officials were carefully burnt. No carbon copy of the documents was made or kept.” Even extra staff wasn’t allocated to the RBI’s currency department just in case that raised any suspicion (Doctor 2016).

It was generally believed that the black-market operations not only held the general community to ransom but also concealed from tax authorities and so failed to contribute their proper share to the public revenues at the expense of honest citizens. Demonetization is designed to achieve the purpose of bringing such operations within the knowledge of the government and of the taxing authorities in particular, with results of considerable value both to the government and to the general public.¹

However, it did not also produce impressive results. The ban really did not have much impact, as the currency of such higher denomination was not accessible to the common people. According to the RBI estimates, through this drive, the government collected 134 crore of the total 143 crore available in the market; only 9 crore was not exchanged, or demonetized. This suggests that only 6.25 percent of the currency was destroyed. Thus, the effect of the ordinance fell short of expectations. For a while, after 1946, black money ceased to be a major issue. It turned out to become more like a currency conversion drive as the government couldn’t achieve much of profit in the cash-strapped economy at that time (Kamath 2016). The drive to extinguish the holdings of illegally accumulated cash was not successful.

The Second Demonetization (January 16, 1978)²

The story of the second demonetization starts with a telephone call made to Mr. R. Janakiraman, a senior official in the Chief Accountant’s Office in the RBI on January 14, 1978. He was said to come to Delhi for an urgent work regarding the exchange control. On reaching Delhi, he was asked to write the demon ordinance within 24 hours. He asked for the previous ordinance as a guidance. All communications with RBI were shut to ward off any speculation. Morarji Desai was the prime minister in the Janata Party government, which demonetized bank notes of 1,000, 5,000, and 10,000. At that time, the union finance minister was H. M. Patel. On January 16, 1978, the ordinance was announced via All India Radio, at 9 a.m. It was through this news bulletin that people came to know the major policy decision. It was also announced that all the banks and treasuries would remain closed the next day, that is, January 17. On the night of Monday, January 16, 1978, the government withdrew from circulation the currency notes of denomination of 1,000 and above, in a bid to counter black money in the economy. The 1978 ordinance was promulgated, providing that “all high-denomination bank notes shall, notwithstanding anything contained in Section 26 of the Reserve Bank of India Act, 1934, cease to be legal tender.” The ordinance was replaced by the High Denomination Banknotes (Demonetization) Act of 1978 on March 30, 1978.

Union Finance Minister H. M. Patel stated in his budget speech on February 28, 1978, that “the demonetization of high-denomination bank notes was a step, primarily aimed at controlling illegal transactions. It is a part of a series of measures which the Government has taken in the public interest and is determined to take against anti-social elements.” The banks were directed to immediately prepare statements of all currency notes of 1,000, 5,000, and 10,000 in their possession. Persons holding such notes could exchange them before January 19, 1978, at the designated branches of the RBI and other public sector banks provided they disclosed the source, the time, and the manner of acquisition along with a proper attestation of identity. If for some reason an individual could not apply for exchange of high-denomination notes by January 19, 1978, they could do so by January 24, 1978 (a week’s extension) to the RBI, together with a satisfactory explanation of the reasons for not applying within the earlier time limit.

The then RBI governor I. G. Patel was not in favor of this exercise when Finance Minister H. M. Patel informed him about the decision to demonetize the high-denomination currency notes. According to him, “such an exercise seldom produces striking results. Most people who accept illegal gratification, or are otherwise the recipients of black money, do not keep their ill-gotten earnings in the form of currency for long. The idea that the black money or wealth is held in the form of the notes tucked away in suit cases or pillow cases is naïve. And in any case, even those who are caught napping—or waiting—will have the chance to convert the notes through paid agents as some provision has to be made to convert at par the notes tendered in small amounts for which explanations cannot be reasonably sought. But the gesture had to be made, and produced much work and little gain” (Patel 2002, p. 159).³

While making a comparison of the two demonetization efforts, one would notice the critical difference that lies in the quantum. The 1946 and 1978 demonetizations effected really high-value notes, which formed a small part of notes in circulation. It is suggested that one can arrive at the estimates by comparing the denomination of the note with the annual per-capita GDP. In 1960, India’s per-capita GDP was 400 (then currency); in 1978, it was 1722; whereas in 2016, it was 103,000 (today’s currency). Thus in 1960, a 1,000 note was 2.5× and in 1978 it was 0.5× per-capita GDP, considerably easy to withdraw. In 2016, the 500 and 1,000 currency notes represent 85 percent of physical money in circulation. At that time, it was considerably less.

Demonetization in 1978 was better implemented than in 1946. In the January 1978 episode, currency worth 1.46 billion (1.7 percent of total notes) in circulation was demonetized. Of this, 1.0 billion (or 68 percent) was tendered back. In 1978, the value of demonetization was very small (only 0.1 percent of GDP). But most holders of high-denomination notes did not turn up at the bank branches to exchange them. They sold them to others who could present them at the bank, with less suspicion. The element of intended surprise and secrecy was also not well maintained and the 1,000-rupee notes were already out of circulation 1 week before the demonetization. Reportedly, the large amounts of high-denomination notes were sent to the Gulf countries, especially to Dubai and Kuwait, a few days before the ordinance was promulgated. In due course, they were presented to the RBI through official channels of the Middle East-based foreign banks that had a connection with such operations. In spite of these limitations, demonetization served some useful, though limited, purpose (Sabhlok 2016). The major benefits claimed are as follows:

Endnotes