Demonetisation: India’s unprecedented move against corruption
21 Mar 2017

“Corruption, black money and counterfeit notes had become so rampant in India’s social fabric, that even honest people were brought to their knees. In this fight, it is clear that you would like to walk shoulder to shoulder with us”

On November 8, 2016, Indian Prime Minister Narendra Modi announced in a televised speech that 500 and 1,000 rupee notes would no longer be legal tender, swiftly rendering 86 per cent of cash in the country invalid.

The chaos that ensued was captured by the throngs of people waiting in line outside banks and cash machines across the country. In a few extreme cases, tragic deaths were reported: people dying because they were unable to pay for emergency care at hospitals, or collapsing while waiting in endless queues. The causal relationship between demonetisation and the deaths has been questioned but they are tragic nevertheless.

For Modi though, this was his great leap in the fight against India’s endemic corruption. (A recent report by Transparency International revealed India to have the highest rate of bribe paying in the Asia-Pacific region, with two-thirds of respondents reporting bribing officials to get access to services.) Modi rode to power in 2014 on the promise of renewing economic growth and, most significantly, purging the country of black money. Irked by accusations that little had changed since he took charge, demonetisation was his bold move to prove to critics that something was being done.

Modi acknowledged that the move would bring hardship, but insisted the benefits would outweigh the costs. “Corruption, black money and counterfeit notes had become so rampant in India’s social fabric, that even honest people were brought to their knees. In this fight, it is clear that you would like to walk shoulder to shoulder with us,” he said in his New Year’s eve address to the nation.

The criticism of Modi that followed was almost deafening. Demonetisation was called a despotic and populist move that made little sense in reality. Economists criticised the haphazard implementation and the needless dent to economic growth. Sure enough, on January 2017, the IMF and the World Bank cut India’s projected GDP growth sharply, by 1 per cent and 0.6 per cent respectively.

The economic rationale

In mid-2016, India was one of the world’s fastest growing economies, with GDP increasing annually at 7.3 per cent, according to data released by the Indian Central Statistics Office (CSO). With steady growth and price stability, what was the rationale for demonetisation?

The stated objective was to eliminate black money and so counter its use in subversive activities like espionage, arms dealing, the drug trade and terrorism. A large bulk of cash is held in India, especially in higher denomination bills, that serves tax evasion and crime. Theoretically then, invalidating these notes would strike a big blow to this parallel economy.

Retrospectively, additional objectives were added to the list, including widening the tax base, curbing real estate prices and moving towards a digital economy.

Replacing notes is also a way to tackle counterfeiting. In 2015-16, 650,000 counterfeit notes were detected in commercial banks in India, with 500 and 1,000-denomination notes accounting for nearly two-thirds of the total, according to data from the Reserve Bank of India (RBI).

“I was asked why we brought demonetisation into effect when the economy is doing well. A doctor would say that the best time for surgery is when the body is healthy,” said Modi in a speech in Parliament.

However, for a country with such a vast population—and one in which almost 70 per cent of consumer transactions are carried out in cash—the immediate effects of demonetisation were pretty catastrophic. As economist Kenneth Rogoff, whose book The Curse Of Cash talks about calibrating the use of cash, pointed out in his blog, “The idea of eliminating large notes and not replacing them is not aimed at developing countries, where the share of people without effective access to banking is just too large.” In India about 53 per cent of the population have bank accounts, but a high number of these are dormant, according to a report by the World Bank.

India’s approach to demonetisation has, in fact, been fundamentally different to that which Rogoff advocates. He argues for a gradual phase-out and an elimination of high denomination notes altogether. India’s demonetisation has instead introduced an even higher denomination—the 2,000 Indian Rupee note.

Rogoff does not rule out the long-term benefits of demonetisation in India but notes: “What is happening is an extremely ambitious step of a staggering scale that is immediately affecting 1.2 billion people.”

The impact: Short term pain, long term gain?

Five months on, what has the impact of demonetisation been? The government hoped that a sizeable percentage of the cash estimated to be in circulation would not return to the system. This would signal that hordes of black money had been destroyed.

But so far, the RBI estimates that close to 90 per cent of the de-legalised notes have returned. It expects the number in the official figures, due for release later this year, to be even higher.

“The government had presumed that about 15 per cent of the currency would not come back … But it now seems like the amount of black money in circulation was grossly over estimated,” said Mayank Jha, consultant for economic policy at the Confederation of Indian Industries (“CII”). “It is still premature to judge its impact but demonetisation only targets black money held in cash and does not affect the flow of income from corruption and tax evasion. Moreover, only a small proportion of undeclared wealth is held in cash. While the government has had limited success to the extent that so much money has come back into the banking system, it isn’t all white.”

With methods both varied and ingenious, criminals have found their way round the ban.

One common route involves using poor people as human mules, paying them a commission to put money into their government-enabled Jan Dhan (no frills) bank accounts. The money is then moved out at a later date. Money laundering networks have even organised large numbers of individuals to ‘smurf’ huge sums of cash, making numerous individual deposits at levels below the maximums set by banks.

Another laundering method involves buying jewellery, especially gold, with back-dated bills. Gold prices saw a sharp rise in price over December, forcing the government to ask jewellers to record and provide details of all transactions.

The real estate industry, which accounts for a large share of black money in the country, has also been attracting investment. Apartments are sold at an inflated rate in exchange for the banned notes, which are then laundered into the banking system in a variety of ways.

Perhaps most creatively criminals have made use of religious institutions, which are exempt from taxes. The government made sure that temples in India would not be interrogated about their deposits. Some temple managers deposited money they claimed came from ‘anonymous donations’, transferring it in due course to the original holders in exchange for a generous commission.

One other route of note involves the tribal communities in India’s north-eastern states, who again are exempted from paying taxes on income from any source. In short, it appears, that the effect of demonetisation on tax evasion has been limited.

But some analysts take a more positive view. Udith Sikand, lead Asia analyst at Gavekal Research, told KYC360: “People will find ways to work around the system. But it is premature to suggest that because almost all the money has returned, the move has failed. Income tax officials have only just gotten around to sifting through the data on deposits of old currency notes—for instance, they have just recently fired the first salvo by asking around 1.8 million account holders to explain their deposits. No doubt, given the vast amount of discretionary power tax officials have, there will be some water seeping through the cracks, but to suggest that there is a Titanic-sized gap in the hull is hyperbole in my view.”

Less debatable is the limited impact of demonetisation on terrorism, drug smuggling and other organised crime. Militants and extremists in conflict areas were initially thought to have suffered a setback in terms of financing terrorist activities, smuggling and arms deals. But reports are now emerging that it was merely a slowdown and violence, especially in Jammu and Kashmir, will soon return.

The digital economy

Demonetisation may have been less successful than hoped at preventing criminality, but the story is not entirely negative. Initial signs suggest that the government is gaining some traction in its goal of stimulating a digital revolution and encouraging citizens to use cashless technology.

Data released by the RBI from November on “payment systems indicators” show a sharp increase in debit card transactions and prepaid payments instruments including mobile wallets and prepaid vouchers. Debit cards were swiped at merchant points 234 million times, double the monthly average of the first nine months in 2016.

However, the same data for January 2017 shows a decline in such transactions, down 10 per cent on the previous month. This suggests that the rise in digital payments may not be sustained once the liquidity crunch eases. “The institutional framework needs to be strengthened first to sustain digitalisation because in India, people have a hard time trusting formal institutions that are not set up visibly. For a country where a majority of its people still live in rural areas, only about 50 per cent have access to financial institutions and where the Cash-GDP ratio is very high, financial inclusion through digitalisation just isn’t an option yet,” said Mayank Jha of the CII.

His sentiment was echoed by India’s Chief Economic Adviser, Arvind Subramanian who noted on the official Economic Survey document: “Digitalisation is not a panacea, nor is cash all bad. The transition to digitalisation must be gradual, take full account of the digitally deprived, respect rather than dictate choice and be inclusive rather than controlled.”

A note of optimism

The outcome of demonetisation in India will be monitored and debated for years to come, but there is still hope that the long-term gains will outweigh the short-term costs. The OECD has said in its economic survey report for India that the short-term cost of demonetisation is transitory and that the move will have long term benefits, complementing other initiatives to fight black money and tax evasion.

An IMF report strikes a similar note, while the Indian Central Statistics Office estimates India’s real GDP growth for the quarter ending December 2016 at 7 per cent, bucking most predictions. (An analysts poll by Reuters had forecasted 6.4 per cent growth for the same period.)

While analysts and economists alike debate the true impact of those numbers, Rogoff sums it up best when he writes in his blog: “The long-run gains depend on implementation, and it could take years to know how history will view this unprecedented move.”

Politics trumps economics: The electoral reward

Alternatively, it has been widely argued that demonetisation was a political, rather than an economic move. Clearly, attempts to explain the economic impact of demonetisation within a single narrative has been challenging for a country as complex as India. But for now Modi’s gamble seems to have paid off, at least politically.

Five states were set to go to the polls including India’s most populous state, Uttar Pradesh, when Modi announced the demonetisation. The strike on black money could have been a strike against his political rivals’ cash reserves in the run up to the state assembly elections. “Black money is routinely used to fund elections and help buy allegiance ahead of elections. The timing couldn’t have been better,” said Karan Pradhan, executive news producer at

Consequently, the results of the elections, announced on March 11, reveal that despite the disruption caused by the move, Modi and the Bhartiya Janata Party (BJP) have managed to sway voters in their favour. The BJP won a landslide victory in bellwether state Uttar Pradesh – where it was looking to unseat the local incumbent and see off another challenger – capturing 312 seats out of 403 in the state assembly. The party will now also assume power in three other states under different coalitions.

The victory has been heralded as a referendum to the demonetisation. For now, the election has overshadowed the economic consequences of Modi’s highly disruptive and unprecedented move. Despite the uncertainty of the true impact of demonetisation, it seems that politics has trumped economics, if only briefly.

Author profile: Alem Ao is a financial journalist based in London.

Advance your CPD minutes for this content, by signing up and using the CPD Wallet