CHAPTER 8

Recent Demonetization of Indian Currency

The recent demonetization was perhaps India’s boldest policy experiment in over a quarter of a century. It was an unusual and courageous experiment in a country of the size of India. This chapter describes the mechanism of operation of demonetization of November 8, 2016.

The Background of the Demonetization

Prior to the demonetization, there was an unprecedented rise in the circulation of high-value notes (500 and 1,000) from 1.5 lakh crore in 2004 to about 15.5 lakh crore in October 2016, their share in the total currency in circulation going up from 34 percent to over 86 percent. According to the RBI, a third of the high-value notes that moved out of the banking system never returned. One can easily infer that this huge unmonitored cash was financing and further fueling the accumulation of black money in the economy (Gurumurthy 2017).

This was manifest in the steep rise in gold, shares, and land prices by almost 10 times during the 6-year period from 2004 to 2010, as compared to the previous 5 years, 1999 to 2004. That asset price rise was not stoked by the matching real growth. It was the other way round. The spurious rise in asset prices generated the mirage of high growth in India like what happened in the United States prior to 2008. The high GDP growth during 2004 to 2010 was just wealth-led growth. “The working capital of black market operations is believed to be held in a large measure in the form of high denomination notes, and Government is aware of the persistent public demand for effective action against these enemies of public welfare.”¹ The Direct Tax Inquiry Committee under the chairmanship of K. N. Wanchoo (1971) was appointed “to examine and suggest legal and administrative measures for countering evasion and avoidance of direct taxes,” which suggested demonetization as a measure to unearth and counter the spread of black money. It was not even the first time that the aim of ridding the economy of black money was invoked by the government to demonetize the high-value currency notes. The same reason was put forward in 1946 and 1978 while demonetizing the Indian rupee.

The Third Demonetization of Indian Currency: November 8, 2016

On the evening of November 8, 2016, when Prime Minister Narendra Modi, in a nationally televised broadcast, announced that 500 and 1,000 denomination notes would cease to be the legal tender from that midnight, he specified three objectives of such a step: (i) checking counterfeit currencies, (ii) fighting black money, and (iii) countering subversive activities that were harming India’s security and economy. The whole country received the announcement with awe and dismay. However, the lower denomination 10, 20, 50, and 100 notes and the coins were to continue to be valid. He further announced that the new notes of 500 and 2,000 would be introduced shortly. On October 28, 2016, the total number of banknotes in circulation in India was 17.77 trillion (U.S. $260 billion). In terms of value, total banknotes in circulation stood at 16.42 trillion (U.S.$240 billion), of which nearly 86 percent (around 14.18 trillion, or U.S.$210 billion) were 500 and 1,000 banknotes.² They were taken out of circulation from November 8, 2016. The demonetization was announced and took effect with, perhaps, the shortest lag in an economic policy decision of such a high magnitude.

In this context, it would be good to remember that a new 500 note was introduced in 1987 and 1,000 was reintroduced in the year 2000 in substantial quantity to contain inflation. The RBI earlier removed pre-2005 notes of all denominations from circulation as they had fewer security features compared to the new notes. The process of removing the older notes from circulation continued for nearly 1 year. The deadline was extended until December 2015, and those notes continued to remain a legal tender until November 8, 2016. This was not exactly demonetization, but removing from circulation, and has now subsumed into the present demonetization. In November 2016, new currency notes of 500 and 2,000 were introduced.

Differences between 1978 and 2016

The following are the distinctive features of demonetizations of 1978 and 2016 (Rajakumar and Shetty 2016):

I.	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). However, the 2016 demonetization effort covers 86 percent of the total currency in circulation (11 percent of GDP).
II.	In 1978, 1,000 and higher value notes were almost impossible to possess in earlier years for the common man given the value of these amounts then. Because of that, demonetization received limited public attention and had little impact on the daily lives of people. High-denomination notes demonetized at that time formed just a minuscule fraction—about 0.6 percent—of the total currency in circulation. Further, the demonetized notes were of significantly high value, having little use for common people. The current situation is different: the demonetized 500 and 1,000 notes constitute 86.9 percent of total notes in circulation by value.
III.	In 1978, a large portion—45 percent of the high denomination notes in circulation or about 53 percent of the high denomination notes tendered for conversion—were with banks and government treasuries and not with the public. However, in 2016, only 96,080 crore or just about 5 percent of the total notes in circulation were with banks and government treasuries. In the first week of November 2016, when the current demonetization took place, about 95 percent of such currencies were with the public.
IV.	The motivation behind the 1978 and 2016 actions is important. According to the RBI, in recent years, there has been an increased incidence of fake notes in higher denominations, and those notes are used by terrorists and black money hoarders. The annual growth rates in total currency, as well as those in high-denomination notes, have been much higher than the nominal GDP growth (Rajakumar and Shetty 2016).

Here, it is interesting to note that unlike in 2016, in 1978, the government did not have the backing of I. G. Patel, the then RBI governor, who was not in favor of the step. He believed that the ban was implemented simply to immobilize the funds of the opposition party. Patel also believed that people never store black money in the form of currency for too long. It didn’t have much effect on the people and affected only the privileged few. He asserted that steps like these rarely have striking results. However, the November 2016 ban had shaken the whole country.

Legal Aspect of Demonetization in India³

Let us now look at some legal aspect of demonetization in India. Like every economic and political measure, demonetization also has a valid place in the Indian law books. The legal basis for demonetizing currency can be found in Section 26 of the Reserve Bank of India Act, 1934. Under subsection (2) of this section, the union government is given the power to declare that any notes issued by the RBI will no longer be legal tender. The only procedural requirement is that the Board of the RBI recommends the same to the union government. In fact, in 1978, demonetization was carried out under a special legislation, namely, the High Denomination Bank Notes (Demonetization) Act, 1978. Former Prime Minister Morarji Desai announced the ban over the radio, after which the banks were closed the following day. In 2016, Narendra Modi announced the currency ban in an address that was broadcasted across all news channels. Both the affairs were kept confidential. The previous demonetization exercises were carried out through ordinance, which later became law passed by the competent legislature. In the present case, the legal tender law was all that was changed in the government’s demonetization order.

Judicial Review

While demonetization per se is probably legally sound, a number of legal issues were raised and some 40 petitions are pending disposal before the Supreme Court (SC) and around 50 before various high courts. The SC decided to examine all the aspects of demonetization. It referred to the larger issue of examining the constitutional validity of the decision to a five-judge bench on December 16, 2016. The apex court framed nine issues for adjudication by a five-judge Constitution Bench for authoritative pronouncement on the government’s demonetization decision. It also stayed the hearing of all petitions related to demonetization filed in various high courts in the country. The following are the nine queries to be addressed by the SC⁴:

An important point to note in the SC’s interim order is that it recognized that in economic matters it should adopt a “stay of f ” policy.

Objectives

Monetary reforms are generally done to deal with conditions of hyperinflation, black money hoarding, and corruption. The demonetization strategy tried before had limited success. The objective of the earlier demonetization was not the same, so comparing them to the current situation would not be proper. It is important to note that the situation in India is completely different from what it was in other countries at the time of demonetization. India is not the only country with rising anticash movement as the fight against cash-dominated economy is to stay and could well intensify (Butani 2016). The present demonetization has many objectives, and the rationale given by the government is as follows:

I.	The major objective was to attack the menace of black money/parallel economy/shadow economy.
II.	The cash circulation in India is directly connected to corruption; hence, it wants to reduce the cash transactions. India is more reliant on cash as a form of transactions compared to other countries. India has one of the highest levels of currencies in circulation, which is more than 12 percent of its GDP value; the 1,000 and 500 notes account for 24.4 percent (around 2,300 crore pieces) of currencies in circulation but for over 85 percent in terms of the value of the currency in circulation.5 Eliminating high-value notes will shrink the use of black money generation avenues.
III.	Demonetization would be a major step toward forming a cashless economy.
IV.	It would tackle the threat of counterfeit currency.
V.	It would prevent terrorist activities/terror funding as cash is being used for such purposes.

Globally, the biggest sectors that have shadow economies happen to be those that are extremely cash reliant, like construction, real estate, trading, transport, and wholesale and retail businesses. The financial corruption involved the currency notes of bigger denominations, which shatter down the economic, social, as well as political stability of a country. Terrorism and terror funding, human trafficking, drugs, money laundering, counterfeits, and politics, all require anonymity for survival. The objective of ending all these menace is expected to be achieved through demonetization.

Counterfeit money has been an ongoing problem and is often tied to “terror” or insurgency funding. Counterfeit notes, mostly in high denominations—injected into India through porous border with neighboring countries—have been a matter of great concern for quite some time. Pakistan has been printing fake Indian currency at its government printing press in Quetta and its security press in Karachi. The enemy nation funnels the counterfeit currency through the frontier at Jammu and Kashmir and via India’s porous border with Bangladesh and Nepal.⁶ Besides diluting the underlying strength of the economy, this has been the cheapest source of terror financing in India. Detecting counterfeit notes, chasing culprits responsible for pumping such notes into India, and weeding them out from an economy of this country through enforcement agencies have been a Herculean task.⁷ A study conducted by Indian Statistical Institute (ISI), Kolkata, on behalf of the National Investigation Agency (NIA) suggests that fake Indian currency notes (FICN), amounting to 400 crore, are in circulation in the country at any given point of time and around 70 crore fake notes are pumped into Indian economy every year. The estimation is based on the recovery and the seizure made by various government agencies. However, the actual figure could be much larger.⁸ Most of the fake currencies circulated in India are of 500 and 1,000 denominations. In accordance with the global standards, the RBI has now decided to change the security features of higher-denomination banknotes of 2,000 and 500, every 3 to 4 years.⁹

The demonetization would cripple the design of financial terrorism by overseas enemies, sometimes operating in connivance with the unscrupulous elements within the country. The root of all these activities is black money. The fungibility of black money reveals that over seven decades, the parallel economy has so spectacularly permeated the life around us that it has got completely intertwined with the formal economy.

Thus, the motivations for demonetization are many. Nayyar (2016) has observed that “a clear separation of the objectives from its consequences would have appealed to a reasoned mind too. The stated objective is economic—to eradicate black money, as also to combat corruption, smuggling, and counterfeit notes. The unstated objective is political. It must be recognized that economics and politics, closely intertwined, are inseparable. Indeed, their interaction is likely to shape future outcomes.” Prudent accounting and policy must take note of the larger macroeconomic implications.

Academicians looked at demonetization from different angles—fiscal, monetary, and political. The political motive is to have a sound grasp on the monitoring of defeating tax evasion and corruption (“black money”) while increasing oversight of citizen activities. The fiscal and monetary goals are meant to generate higher revenue and force more economic activity into the banking system. It is also expected that demonetization would help in reducing the interest rates in the banking system amid the flush of huge funds and possibility of the passing effect of the fall in the interest rates to the investment in the country (Nataraj 2017). Demonetization has also been considered as a mechanism to drive financial inclusion and use digital financial services (DFS). Demonetization required virtually all adult Indians to engage, directly or indirectly, with a formal financial institution.

In short, the major objectives of the 2016 demonetization of Indian currency were

Operational Mechanism

Demonetization policy has been termed as the greatest financial reform. It is an act of creative destruction. It has become important to everyone because everyone got affected by this—businesspeople, salaried people, housewives, students, working professionals, politicians, etc. The operational mechanics of demonetization were governed by two notifications, issued by India’s Ministry of Finance (MoF) and the RBI. Both were issued shortly after the prime minister’s announcement. Technically, demonetization meant withdrawing the legal tender character of all existing 500 and 1,000 notes and introducing the new notes, valued at 500 and 2,000. The two notifications specified how this process was to be regulated, including over-the-counter exchanges of old notes and daily and weekly limits for withdrawals at bank counters and ATMs. The important fact to note is the way demonetization was communicated. There seems to be lack of insight among government bodies about the reasoning behind demonetization.

One issue that dominated the Indian public discourse on demonetization was its evolutionary nature. Between November 8 and December 30, the last day to exchange or deposit old notes, the RBI issued 50 notifications to guide and regulate the process and to remind the actors, namely, public and private sector banks, of their legal obligations. Some of these were of an advisory nature but a large proportion provided substantive changes to the workings of the system. The MoF, for its part, issued 19 notifications during the same time frame, some reflecting RBI notifications and others introducing additional changes. The number of modifications was so large that the RBI created a website entitled “All you wanted to know from RBI,” referencing the 57 notifications and 27 press releases (as of March 1, 2017) that the central bank had issued on demonetization (RBI 2017).¹⁰

From the public’s perspective, the most visible changes to the operational mechanics of demonetization concerned exchanging and depositing old notes, as well as caps on the availability of new notes. By the end of the year 2016, the RBI had issued nine notifications on the exchange and deposit process and five on the cash-withdrawal limits. A significant set of the RBI and MoF notifications pertained to the agricultural sector, where nearly half of India’s population is employed, addressing complaints that farmers were unable to purchase supplies for the ongoing sowing season. The criticism leveled against demonetization led to a number of modifications to the operational mechanics of demonetization, which, in turn, led to accusations that the government had failed to think through the operation properly (Beyes and Bhattacharya 2017).

These frequent and often sudden operational changes had a direct impact on the population. Policy makers, with their own actions, destabilized a perfectly stable and one of the fastest growing economies in the world. The authorities must have known that changing notes was going to be a huge logistical exercise. It seems that the government is simply trying to learn through the trial-and-error method. Bank employees had worked continuously without taking a day off. Their cooperation matters a lot. Given this scenario, demonetization was resorted to tackle distortions in the economy. The fact is cash economy has moved deep into the Indian economy. But it is important to remember that by and large cash economy does not connote illicit economy. The problem lies in its unorganized economy.

Endnotes