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Can Demonitization in India Succeed?

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In an address to the country on the evening of November 8th, Indian Prime Minister Narendra Modi made a shock announcement that 500 and 1000 rupee notes were, from the following morning, no longer to be legal tender. The move to take the bills out of circulation—“demonetization” being the economic term—led to a frenzied aftermath. 

Most of the money circulating in India comes in 500 and 1000 rupee notes, rendering colossal sums of cash worthless unless exchanged within a relatively brief window of time till the end of the calendar year. Astonishingly long lines formed at once outside bank branches across the country, with some waiting for over several hours to exchange small bundles of notes.

The government’s objective was to expose illegally acquired “black money”—frequently the fruits of corrupt activity and the enablers of further shady dealings. Many real-estate dealings in India, for example, occur at least partly in cash to avoid leaving a traceable trail of money. This black money circumvents the banking system and any institutional oversight, thereby allowing criminal activity to flourish.

By declaring the 500 and 1000 notes invalid, the government essentially forced those with illegally obtained money to either forego the cash or to deposit it in banks and be placed under investigation as a result. The government does not intend to investigate new deposits under 250,000 rupees, but rather only large deposits that may signify illicit activity.

It is important to note, however, that most large-denomination notes in India are not in circulation due to nefarious purposes. A significant portion of India’s economy is informal, operating outside the banking system and away from the eyes of the taxman. This is largely a result of severe red-tape and other governmental impediments to formal business. Much informal activity is not illegal, and some has in fact been tacitly encourage by government officials in the past as helping to drive economic growth.

Those in the informal economy, and those holding cash at home, are being faced with the massive inconvenience of waiting in lengthy lines to exchange notes. Lower- and middle- class savers are being faced with a significant burden in the form of lost work time and income.

The general consensus among economists is that demonetization will have negative short-term economic consequences. This is hardly surprising, given the severe disruption to business and the very adverse impact on overall productivity.

In response to sharp and relentless criticism that the initiative was inflicting great harm upon the poor and farmers, the government responded with a patchwork of measures including limited exemptions for certain groups and some extensions.

The longer term effects of the measure, and its ability to tackle the key issue of corruption, are a matter of considerable contention. Some argue that the interference to economic activity may see business come to a complete standstill for enough time to seriously harm the economy beyond short-term effects. Many contend that, instead of large-scale bureaucratic action, reducing taxes and government regulation would have had the effect of boosting economic growth and reducing the incentive to avoid tax.

Another matter of concern is the possibility that the drive does not help expose much illicit money after all. Much illegally acquired money is stored not in cash, but instead in assets such as gold or real estate. In addition, those with cash stockpiles can simply distribute the money among many others, ask them to deposit it in personal bank accounts, and then transfer it back later for a fee.

Despite the controversy, it is clear that the urgency and swiftness of the Indian government in implementing demonetization has sent a strong symbolic message that corruption will not be tolerated and that the government sees tackling corruption as a top priority. Was demonetization the best way to do this? Considering its potentially damaging economic ramifications and limited efficacy, maybe not. Ultimately, the stern warning that was sent out by demonetization may be its greatest positive.


A version of this article appeared in the South China Morning Post's Young Post: http://yp.scmp.com/over-to-you/columns/article/105734/indian-prime-minister-narendra-modis-demonetisation-meant-tackle

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