Demonetization in India and the Misuse of Shock Economics

Last November, this column discussed the potential effects of the demonetization of Indian banknotes. However, the article was written while the shock of the initial announcement was still fresh and could only report what was known at the time, providing background information regarding the scale of Indian black money and offering quick glances at things to look out for in the near future. Now that the old 500 and 1, 000 rupee (₹) banknotes have officially ceased to be considered legal tender as of December 30th, an update to the initial story seems necessary.

Modi’s “Surgical Strike” on India’s Black Money Problem

Originally, the suddenness of demonetization was justified on the grounds that it would deny those hoarding black money (money acquired through illegal or semi-legal means) a chance to launder their dirty cash ahead of time. Deemed a “surgical strike” by its proponents, demonetization was billed as a way of leveraging the Indian economy’s heavy reliance on cash (98% of all transactions involve cash, and 86% of all bills in circulation were the demonetized 500 and 1,000) to either catch criminals and hoarders of black money or force them to forfeit their stashes. As reported last fall, the thinking went that while large stashes of newly demonetized cash earned via legitimate commerce could be explained with receipts and income statements, demonetized cash earned via illegitimate commerce would come with no valid receipt or income statement and would not be eligible to be exchanged for the new bills. In theory, those holding no black money would lose nothing, while those with black money would be forced to choose between admitting criminal activity and outright losing a substantial amount of money.

Unfortunately, this storyline has not played out in practice. As the December 30th deadline for exchanging old bills for new ones passed, Bloomberg reported that ₹14.97 trillion of the ₹15.4 trillion that was demonetized (over 97%) had been validated and exchanged for new bills. Such a high rate of validation suggests that either India’s shadow economy is far smaller than initially estimated, or that hoarders of black money were able to successfully launder their dark fortunes in a short amount of time, despite the promises of a “surgical strike.” Given that estimates of the size of India’s shadow economy are consistently reported in the billions and was estimated at around ₹25 trillion as recently as June 2016 – it seems farfetched to assume that less than 3% of the most popular bills in an overwhelmingly cash-driven economy can be attributed to black money. Rather, such a high rate of validation more likely indicates that holders of black money were able to launder their money some way or another.

While it is unclear at this point exactly how this was done on such a complete scale, there have been reports of bankers knowingly exchanging counterfeit or unaccounted-for bills in return for payment. Interestingly, while gold prices jumped over ₹1,000 per 10g the day after demonetization was announced after staying relatively steady the week before, they immediately returned roughly to pre-demonetization levels a day later and actually steadily fell through November and December. This sharp increase in demand, followed by a quick correction and steady fall, suggests that while black money hoarders may have immediately turned to gold in order to launder their dark fortunes, this common laundering technique was not a major contributor to the unexpectedly high validation rate of old bills. Regardless of the precise technique of the laundering, the fact that over 97% of illegal bills were validated indicates that black money hoarders were able to successfully side-step Mr. Modi’s “surgical strike” against them.

Sadly, not everyone emerged unscathed from the “surgical strike.” As reported last fall, Indian housewives who had spent generations collecting personal fortunes secret from their husbands were now forced to make a choice between losing those fortunes altogether, or admitting to their families that they had been siphoning money from their husbands. Given that many women in India hold second-class economic citizenship and are kept from handling money and making purchases, these secret stashes of wealth represent a rare form of financial and personal freedom for Indian women. Now, for many, that freedom has likely vanished, perhaps along with the trust of their husbands.

More saliently, dozens of people have died as a result of demonetization, primarily due to exposure from standing in bank queues for hours and from hospitals refusing to accept old bills. Mamata Banajaree, a member of the opposition to Mr. Modi, claimed that 112 people in total had died due to demonetization between the time it was announced and the December 30th deadline. Though it is unclear as to how Mr. Banajaree came to exact number, it should be noted there were at least total 55 deaths reported merely 10 days after demonetization was announced. Because withdrawals of the new bills were limited to ₹2,000 a day during the 50 day exchange window, and banks often ran out of new bills before queues were exhausted, people looking to exchange demonetized bills often had to stand outside for hours day after day in order to exchange all of their bills. While limiting the withdrawal amount meant to prohibit black money hoarders from exchanging their entire fortunes at once, it also kept old or sick Indians trapped outside day after day, likely contributing to such a seemingly high death toll.

A Move to the Digital Economy

However, while demonetization may have come up short in its public goal of surgically striking hoarders of black money, evidence exists to suggest that it may still yield positive results in the story of India’s long-term growth. By November 30th, less than a month after demonetization was announced, 30 million new bank accounts had been opened nationwide, and it has been reported that many of the previously “dormant” bank accounts (accounts without any transactions for 24 months or more) have awoken as well. Furthermore, as money moves from cash to digital form, previously reliable practitioners of the cash-only business model, such as laundry washers, rickshaw drivers, and street vendors, have started offering digital payment options. Paytm, an electronic payment service, reported over 14 million new accounts in November, and Oxigen Wallet, a rival e-payment service, has reported a 167% increase in daily users since November 8th. Though only small steps on a long road, this is good evidence that India’s journey toward a digital economy has been nudged forward by the shock of demonetization.

The obvious benefit of a digitized economy is that it makes economic activity much easier to regulate and tax, due to greater ease of electronically tracing transactions as opposed to them being conducted under the table with largely untraceable cash. On December 29th, just before the 50 day window for exchanging notes expired, India’s Finance Minister, Arun Jaitley, declared demonetization a success for tax collection purposes. According to Jaitley, direct tax collection (collections of taxes directly billed by the government, such as income taxes) increased 14.4% through December 19th, and indirect tax collection (collections of taxes that are paid to the government through a third party, such as sales taxes) increased by 26.6% through the end of November. Moreover, government reports from 47 cities in India have reported a combined 268% increase in tax revenue for November 2016 as compared to the previous November. For a developing economy, such a dramatic increase in tax collection efficiency is especially important , and demonetization should be given credit for nudging the Indian economy down the path toward digitization, even if it did so as an afterthought to punishing black money hoarders.

Of course, while the digitization of India’s economy is increasing at record levels, it still remains an overwhelmingly cash-driven economy at the moment. This is especially true in rural areas, where access to banking services often involves walking miles to the nearest ATM, rendering economic digitization inconvenient at best. Moreover, stores and shops in rural areas tend not to be equipped to accept digital payment, fostering little to no immediate need to open a bank account. Similarly, truckers and transportation services rely heavily on cash and walked off the job when they ran out of legal tender in the early days of demonetization, oftentimes abandoning their cargo on the side of the road. Getting transportation and cargo-moving providers to go digital in the near future seems difficult, as it would require them to have access to e-payment options wherever they go, which would involve all or most of the entire country getting on board with digitization.

Lessons for the Future

While the dust is still settling and new information about the effectiveness of demonetization is coming in every day, a clear question has emerged: why make the move a surprise? Of course, Mr. Modi made it known at the outset that demonetization was meant to catch hoarders of black money off guard and therefore needed it to be a surprise in order to deny hoarders a chance to plan ahead. However, that over 97% of the demonetized currency was validated suggests that hoarders of black money were able to adjust on the fly despite a lack of warning. Instead, those who were unable to adjust tended to be the poor, who could not afford to queue at a bank for hours, truckers and transportation services who also couldn’t afford to queue at a bank for hours and who rely on being able to use cash anywhere to refuel and conduct business, and those in rural areas without easy access to banking services or e-payment infrastructure. Making demonetization a surprise hurt these types of people the most by inconveniencing them after denying them the opportunity to plan ahead. As has been shown before, and as Mr. Modi should have been expected to consider beforehand, it is often the most disadvantaged that are most severely impacted by the economics of shock.

Additionally, there is little evidence to suggest that demonetization needed to be a surprise in order to have the effect it has had on economic digitization. In convincing Indians to go digital, Mr. Modi only needed to give them a reason to get to the bank and not trust cash so blindly, and there is no reason why this couldn’t have been accomplished via a lengthy rollout of demonetization, wherein the public would be warned months or even a year before 86% of the bills in circulation were to be invalidated. This would allow Indians of all types of backgrounds to plan ahead, but would still force them to go to a bank and exchange or deposit their old bills eventually, thereby achieving the major win of demonetization without throwing much of the nation’s economy in temporary turmoil. For future governments looking to fight black money or digitize their economies, the lesson they may learn from India’s experience with demonetization should simply be to take their time.

Of course, politics do matter in economic decisions, and demonetization was arguably just as much a political move as it was an economic one. For Mr. Modi and his ruling Bharatiya Janata Party (BJP), a grand “surgical strike” against corruption plays better politically than does a slow, methodical nudging of the Indian economy toward digitization. As it happened, Mr. Modi and the BJP were better able to frame demonetization as a grand, patriotic sacrifice for a better India. One might imagine an opposing scenario wherein Mr. Modi rolled out slow banking reforms aimed at digitizing India’s economy, having to drag Indians through months of inconvenience and spend months drumming up support for such a dull measure.

With five states in which the BJP is active holding elections in the coming weeks, it shall be seen how effective Mr. Modi and the BJP can be at continuing to frame their move as one of heroic patriotism. Home to over a fifth of India’s population and comprising a multitude of castes and demographic groups, elections in these five states have been regarded as a referendum on demonetization. Early polling suggests that the BJP is poised to put forth a strong showing in Uttarakhand, and win the large state of Uttar Pradesh, indicating at least an acceptance of the necessity of demonetization.

However, with the polls in the large state of Uttar Pradesh staying open through March 8th and the state of Manipur not voting until March 4th, the BJP’s political opposition still has some time to turn the tide. To do so, they will almost certainly need to brand demonetization as an unnecessarily quick, ill-prepared economic move made with political gain in mind. Luckily for the BJP’s opposition, the economic justification for this narrative is there.