‘Demonetization’: Beyond the Hype


Much hype has surrounded the dramatic
announcement by the PM on 8th November that the existing Rs. 500 and
Rs. 1000 notes would cease to be legal tender within a few hours of that
announcement. Statements such as “A historic step to fight corruption, black
money, terrorism and counterfeit currency” or the “boldest decision in the
financial history of independent India” are representative of the way the
measure has been sought to be described by the ruling regime and its support
brigade. Any criticism of the move has been met by taunts suggesting that it is
nothing but attempts to sabotage the all-out war against corruption, black
money and terrorism launched by the Modi Government. The daily reports in the
media about serpentine queues, non-functioning ATMs and cashless bank branches,
disruption of trade are dismissed as temporary inconveniences which all
‘patriotic’ Indians are ‘cheerfully’ bearing (even though they appear to be
extremely frustrated).

While the Modi regime is trying to frame
the issue in dishonest rich versus suffering poor terms and posing itself as
the defender of the latter, the Government has put out nothing which would
explain clearly the precise mechanism by which the withdrawal/replacement of
the old 500 and 1000 rupee notes would achieve their stated objectives and the
estimated long-term benefits and short-term costs of such a move.It does not
even appear that any proper study that would answer these questions was done before
taking such a drastic measure. In other words, the desirability of the measure
is to be accepted as an article of faith and not something that has been
established through proper reasoning and analysis. The hype is simply the
instrument for this propaganda and its associated cover-up.
Any dispassionate analysis of the move
and its possible implications would, however, raise certain very troubling
questions about what is referred to somewhat inaccurately as ‘demonetization’. It
is not that the use of currency or money (which includes more than just
currency) is being eliminated. Formally, an existing set of currency notes is
being replaced by a new set of equivalent value accompanying which would be a
temporary reduction in the quantity of that currency in circulation.
The Transition
The replacement of old currency notes by
new ones (of the same, smaller or larger denominations) necessarily involves a
transition period as the change on such a large scale cannot be done in one go.
The scale in this case is in fact unusually large, different from earlier
demonetizations when currency in denominations too high relative to prevalent
price levels to be held by most people were affected. The current demonetization
requires over 85% of the Rs. 18 lakh crores worth stock of currency in
circulation to be replaced. Roughly 1600 crore 500 rupee and 700 crore 1000
rupee notes have to be thus changed.Moreover, while it is possible for both old
and new currency notes to co-exist and be in use during a transition period,the
current scheme has been designed to eliminate this possibility. The old notes of
500 and 1000 rupee denominations arenotlegally usable generally to
settle transactions during thetransition – which means that for that duration the
quantum of currency available in the hands of the public which can be used to
make payments must be less than what it was just before.
Indeed, the quantum of legitimate currency
in circulation should be less even after the transition period is over.
In the process, some people should have suffered in a loss in the form of a
destruction of their purchasing power. Indeed, unless this is the case the
scheme would have to be deemed a complete failure! The basis for this comes
from the very assumptions underlying the stated objectives of the scheme –
namely to curb fake currency as well as to check ‘black money’. These imply
that some part of the currency in circulation on 8th November would
not be convertible into new notes. Partly this would happen if conversion of
fake currency is refused – and unless that is done, the conversion process
would only replace fake with genuine currency. The other part which would not
get converted is the black money or unaccounted income held as cash which is not
brought forward to be exchanged as those possessing it cannot explain the
origins of these holdings and fear investigation and action.
Several questions thus automatically
arise. What would be the immediate consequences of the disruptive effects on
transactions of the transition? Who will bear the costs of this disruption and the
destruction of purchasing power and to what degree? What would be the long run
consequences of this demonetization – would there be significant benefits which
would outweigh the short-term costs?
The Contractionary
Macroeconomic Impact of ‘Demonetization’
Disruption of transactions during the
transition would happen both because the means to undertake transactions are
not available or cannot be used as well as the fact that time and effort must
be expended by everyone for the specific purpose of changing their old notes or
acquiring the new ones. Further, the general shortage of currency may induce
those holding currency in smaller denominations that are still valid to stretch
their cash balances – hold back the use of such currency for some purposes in
order to preserve them for more essential expenditures.  This would reinforce the shortage of currency,
and also block the use of valid notes because ‘change’ is not available.It
should also be emphasized that any disruption of transactions would also have
multiplier effects as other transactions which are contingent upon preceding
transactions having taken place would also get affected.
Thus, if a shopkeeper is unable to sell
his goods in exchange for money, he may also withhold purchases from his
supplier who in turn may not hire a truck to transport his goods and so
on.Similarly, if a farmer is unable to sell his product at the Mandi in
exchange for cash or get credit in cash from the trader, he may not be able to
purchase seeds and fertilizers from their suppliers. On the other hand a
factory or any other production unit may not be able to undertake production
activity because it is unable to purchase its raw materials and inputs,or pay
wages, with its existing holding of cash and is also unable to convert its
stocks of finished goods into money because the buyers don’t have the means to
buy. Everyone spending time going to a bank or ATM and standing in queues would
also not be able to undertake any work or any other transacting activity at
that time.
Some of the potentially affected
transactions would of course still take place if there was sufficient trust
between transacting parties to convert what might otherwise have been cash
transactions into credit transactions – 
the seller could provide the buyer with the goods or services with
payment being deferred. Some could migrate to non-cash methods of payment
(cheques, cards, electronic transfers, etc.) if such an option were available. Some
transactions may still take placeusing the old currency, legally where
permittedand illegally where the holder of the money has more pressing needs
and lesser ability to convert currency than the receiver of the money and is
willing to pay a cost (‘commission’). Indeed some transactions may even get
created simply for such a purpose.  Some
other transactions may get deferred or postponed till the liquidity crunch ends.
However, there would always be transactions which would simply get cancelled.
In some cases like those of perishables, the cancellation of transactions would
be inevitable as the goods themselves could be destroyed before they are sold.
In other words, during the transition
period economic activity through which incomes are generated – even when they
are not legally illicit activities and will not give rise to unaccounted
incomes – will be disrupted, which means some short run contraction of income
generation. The contraction of economic activity is also something that would
tend to reduce the tax revenues (unless counteracted by the ‘unearthing’ of
black incomes) and therefore government expenditure, which would reinforce the
contractionary effect. While one may debate about its extent, that there will
be some loss of current period GDP cannot be disputed. You cannot suddenly
withdraw a significant part of the currency in circulation in a currency using capitalist
economy and not expect it to have such an effect.Yet the Government and those
supporting the demonetization measure have not put out any estimate of this economic
loss and the basis for such an estimate. This is in stark contrast to the
figures of ‘loss to the nation’ routinely dished out whenever workers go on
One of the perverse trade-offs created by
the demonetization method of dealing with illicit incomes is that the greater
is the proportion of illicit cash holding in total currency holding and the
greater the part that is successfully thwarted from being converted, the
greater would also be the short-run contractionary effect on the economy. This
is because if the conversion of any part of currency holding is blocked, the
purchases that would have been made with that currency by its current holders would
never be made. The destruction of their purchasing power in this case is
through a process that does not place an equivalent amount in the hands of
anyone else to spend.This may be contrasted with an alternative where the
income-tax authorities manage to make those with unaccounted income pay their
taxes – in which case whatever is lost by them in terms of purchasing power is
spent by the government which receives it as revenue. Similarly, if someone
does not have to pay a bribe to get some work done, he or she would be able to
undertake expenditure with that amount instead of the bribe-receiver spending
it. Withdrawal of old currencyon the other hand could inflict a one-timeloss
on recipients of illicit income, but it would do so precisely by the currency
not being converted to keep the income source remaining hidden. Thus, a set of
purchases that would have been made with such currency would not be made at
all, which in turn would have multiplier effects.
It should be obvious that none of this
amounts to saying that counterfeit currency, corruption or black incomes are
essential for the economy and generation of income. Transactions rather than
their illegality is the requirement so that there would be no problem if legitimate
transactions replace ones tainted by illegality. If, however, illicit incomes
are sought to be curbed not by preventing them from being earned or taking that
form but simply by preventing some part of them being spent, then it cannot but
also adversely affect legitimate income generating activity because different
income-generating activities are inter-connected with each other.Not all
economic activity from which illicit income is generated for some is by itself
illegitimate and neither is all economic activity or income earning sustained
by expenditure of illicit incomes. For instance, a businessman evading taxes
and his employees could earn an income from a perfectly legal activity like say
retail trade or production of cloth, as could the shopkeepers or suppliers from
whom the businessman buys with the income that is hidden from income-tax
authorities including the evaded taxes part.The employees or the sellers from
whom the businessman buys may not be guilty of any illegality. On the other
hand, some of the buyers of the businessman could be spending in the process
income earned through bribes.
Who are the
Losers? Only the Black-marketeers?
As should be obvious from the preceding
discussion, the adverse effects of the contractionary macroeconomic impact of
demonetization will certainly not be limited to those who are the real culprits
behind the black economy or counterfeit currency. Indeed, it would be laughable
to suggest that the disruption of income generation and loss of GDP will not
affect the poor and working people of this country. Given theprevailing economic
structure, if economic activity contracts so will the work (in wage as well as
self-employment) available for them and the income they receive. Indeed, for
those who already get so little the consequences would be much more than that
which could be described as a simple ‘temporary inconvenience’.In an economy
where labour is very cheap, the simple aggregate magnitude of this loss may not
give rise to a very large figure but precisely for that reason its impact on
the lives of those affected could be extremely significant. 
The loss of work that is the effect of
the disruption of economic activitymay not always even appear to be linked to
demonetization. It should also be evident that the more visible disruptive
effects on the lives of the poor and working people would be severe, again not
despite but because they have so little. Their dependence on cash, both for their
limited consumption expenditure as well as for holding their meagre savings, is
much greater than those higher up in the income ladder while their ability to access
banking facilities (needed for the conversion), alternative payments mechanisms
and credit ismuch less. At the same time, they also face greater difficulties
in staying away from work to find time to convert their currency holdings.Thus,
while their need to convert their currency may be far more pressing than those
who have access to other means of payment, the difficulties faced may be much
A large majority of Indians, therefore, are
going to experience a double hit because of demonetization – on the one hand it
would reduce the ‘money’ that comes into their hands as remuneration for one or
another kind of work and on the other it would increase the costs of using what
they currently have.  That currency of
smaller denominations has not been affected by the demonetization provides no
solace because at current price levels, the value of even a Rs. 500 or Rs. 1000
note is not very high. Consequently, wages are often received in these denominations
rather than smaller ones. Small savings in cash or lumpsum expenditures (like
on marriages or purchase of a jhuggi or even payment of rent) are also
undertaken by those with low incomes in such denominations. Receipts and
purchases of those who are self-employed (like vegetable vendors, small retailers,
rickshaw pullers, etc.) may be of much higher level than the income generated
from such employment and are also undertaken in larger denomination
currency.  Moreover, the potential
employers of many wage-earners certainly use such currency in the activity for
which employment is created. Only someone with no knowledge of the reality of
the Indian economy can thus argue that only those who are both rich and corrupt
are affected by the withdrawal of the legal tender status of the existing 500
and 1000 rupee notes. In fact, contraction of economic activity will
temporarily hurt some of the highor middle income earning groups even when they
have indulged in no illegality and have access to non-cash means of payment. The
difference is that their difficulties may not be as severe as that of the poor.
Even with regard to the currency that
cannot be converted, it is not true that only the real culprits will suffer the
destruction of their purchasing power. In the case of fake or counterfeit currency,
it is almost by definition true that the creators of fake currency would not be
the ones holding it – such currency goes into circulation only when they use it
for making any payments. Once it goes into circulation and keeps changing hands
– it could at the point of time demonetization happens be in the hands of
anyone.Even the government has accepted that it is almost impossible for people
to distinguish between genuine and fake currency. Imagine for example a
terrorist using fake currency to purchase a sim or pay rent, parts of which are
then used by the retailer and the landlord to purchase their provisions or pay
their employees. At the moment of demonetization, the counterfeit currency may
thus be spread between all these individuals or those they make payments to, none
of whom are responsible for producing it. 
It’s a slightly different scenario when
it comes to genuine currency which is the counterpart of illegal or unaccounted
or unexplainable income. That all such holdings will result in dead losses for their
holders would only be true if it was correctthat the mechanisms by which such income
is hidden cannot be also used to ensure successful conversion into new notes. In
business activities some of it could even be declared as resulting from income
of the current year – which would mean paying taxes at current rates but not a
loss of the entire holding. If declared as proceeds from agricultural income,
even this tax could perhaps be avoided. Alternatively, it could be shown as
proceeds from sales (which is not the same thing as income) intended to be used
to make business related purchases. In short, if the existing mechanisms of keeping
income out of the tax net are not eliminated, and demonetization by itself does
not achieve that result, those with illicit cash holdings might still be able
to beat some of the potential adverse effect on their holdings.
The habitual tax-evaders and
counterfeiters and those who are corrupt may thus find some escape route tocut
their losses, or recoup them through future generation of illicit income. Some
who are not in that category but having to engage in transactions where the
influence of black money is structurally given may, on the other hand, suffer
heavy losses. Everyone knows that the purchase and sale of existing properties
in India often involves a large cash (undeclared) component, to the extent that
an individual transactor often may not be able to either sell or buy a property
if a no cash transaction is insisted upon. Even people who are not fundamentally
dishonest but by chance happen to be among those holding large amount of
currency in the course of property transactions can therefore be hit by a withdrawal
of the currency’s legal tender status.
In short, in an economic context where
legality and illegality co-exist and do not have clearly demarcated spheres,
the distribution of the economic costsof demonetization cannot be distributed
across individuals in society proportionate to their dishonesty and
contribution to illegality. Given that, the justification for the resort to it
must be that it contributes in a big way to achieving longer term objectives
including the curbing of illicit incomes. Does it do that?
The Death Knell
of the Black Economy, Corruption and Counterfeit Currency?
The value of the currency that was in
circulation whose legal tender status has been withdrawn is barely 10 per cent
of one year’s GDP. Some part (4 % of the total currency in circulation) is always
held by banks as cash reserves to cover gaps between deposits and withdrawals
of cash by their customers. All business firms and commercial entities similarly
hold stocks of currency to cover gaps between the receipts and expenditures
involving cash transactions associated with their business.  Almost allindividuals hold at any point of
time some currency in their pockets to meet theirimmediate payment requirements.
While the currency may keep changing hands through transactions, the aggregate
quantity held in the economy as a whole remains unchanged by such transfers. Certainly
all such holding of currency in the economy is not ‘black money’. In fact, even
without the demand for currency created by the black economy the requirement
for currency tends to be significant in an economy like India’s where
capitalist development has over time commodified almost all economic activities
and dragged them into the nexus of money and finance even as it has shut out a
significant part from the accessing the advantages of financial development.
When average incomes are very low and
most the population is rural, as is the case with India, a larger proportion of
transactions would tend to have a size and nature that makes cash the most
convenient method of payment and a larger proportion of people or economic
units would tend to be of a kind who cannot make or receive payment in other
forms.The infrastructure needed for other forms of payment also tends to be
underdeveloped and tends to exclude low-income groups from access. The exceptionally
large ‘informal’ component in Indian capitalism, whose causes are structural, also
constrains the use of non-cash means of payment. On all these counts that make
for greater prevalence of currency use, India leaves far behind all the other
major economies of the world. Despite that, it is not even the case that the currency-GDP
ratio in India is higher than everywhere else – it is in fact lower than in
some advanced economies like Japan.
If all currency holding in the economy is
not resulting from illicit incomes, what is the proportion that is? Even if one
assumes that 25% of it is of that kind and all of it will not be convertible
into new notes, the loss to the black economy as a direct result of
demonetization would be 2.5 per cent of the GDP (of course it will also
experience some of the effects of the general contractionary effect on the
economy). Since estimates of its size place the black economy at anywhere
between 25 to 50 per cent of GDP, the loss to the black economy in the
aggregate would less than 10 per cent. This would leave illicit income earners
still better off than they would be without such income or by declaring them
and paying tax.  Moreover, this would be
a one-off loss leaving untouched the
illicit incomes of earlier years or of the current year that has already been
spent for consumption purposes or to acquire assets (gold, real estate or even
producer goods and goods for trading). The point to realize is that blackincomes
are not ‘earned’ to be permanently hoarded in the form of currency – they keep
getting used in purchases.
It is also not the case that the flow of
illicit money is entirely in the form of currency, whose genuine component by
the way also goes into circulationthrough the formal banking system and keeps recurrently
going in and out of it. In today’s world,large volumes of illicit moneyflows go
through banks and other financial institutions and they also moveacross
international borders– posing a problem even for advanced economies where the
volume of cash transactions is relatively low.It is not Rs. 500 and Rs. 1000
notes that are stashed in Swiss Bank accounts or other offshore entities as
revealed by the “Panama Papers”! Neither are such notes the form in which
investments in Indian financial markets are made by various domestic and
foreign entities whose ultimate beneficial ownership (and even their
nationality) remains hidden. Everyone involved in management of the economy is
familiar with the phenomenon of round-tripping and the use of tax havens by the
wealthy of the world including Indians. Even within the domestic economy, is it
not true that large corporate entities and wealthy Indians with extremely fat
bank accounts and billions of rupees worth of non-cash transactions do manage
to pay bribes and evade taxes?
To put things in perspective, one may
note some figures. Recorded transactions through the banking system in 2015-16
in India were of the value of over Rs. 1800 lakh crores, nearly 14 times the
country’s GDP. A little over 5 crore entities (individuals, firms, companies,
etc.) in India pay income-tax but there are nearly 150 crores deposit accounts
in banks. As on 28 October 2016, the aggregate value of savings, current and
fixed/recurring deposits held in banks by the ‘public’ was Rs. 107 lakh crores
– more than 6 times the value of their currency holding on the same day!
To argue in these circumstances that the
cash using part of the economy is where all illicit income is generated and
hidden would either reflect ignorance and living in the distant past or amount
to engaging in deliberate subterfuge. The demonetization measure, however, has
no effect on the flows that take place through the banking system. 
Identifying durable or long-term effects
of the demonetizationmeasure on illicit income and money is also extremely
difficult.Because it involves at best a one off-loss, it does nothing to
disincentivize future illicit income generation through corruption or
concealing income. The incentive for producing counterfeit currency would
always remain as long as the cost of producing it remains significantly below
its face value. The very fact that it is not the kind of measure that can be
used frequentlyalso works against the fear of possible demonetization being a deterrent
for illicit activities in the future. It is also doubtful whether the process
of conversion into new notes would generate so much useful additional information
as to dramatically improve the ability of the tax administration system to
catch the tax evaders – conversion on such a large scale may in fact not be the
most efficient way of garnering the required information.
Thus, once the old currency is fully
replaced (net of that part which is not converted), there is no reason to not
expect the situationto be back to where it was before the demonetization. The
only difference would be that the currency used in both legitimate and
illegitimate transactions would be the new ones rather than the old. Because
demonetization is toothless in hitting the real sources of illicit income and
its biggest generators, and was preceded by other toothless measures and also
an amnesty scheme, it does not even signal a serious intent of the government
to dealing with the problem of ‘black money’. Those who do not know the world
of black economy may be sold the story about how bold the move is – but those
in the heart of it perhaps know better.
So why then did the government take
recourse to such a dramatic measure? There were clearly some political
calculations behind the move and an expectation that this will help in shoring
up the sagging reputation of a government and its leader because of its failure
to deliver on the expectations that had generated – both among the dominant
corporate interests as well as ordinary people. That failure in turn reflects
the harsh realities of the neo-liberal economic strategy to which the all
governments have been wedded in the last 25 years and the current one to the
greatest degree. That strategy has contributed to a situation where tax revenuesin
India are constrained by bothlow tax rates on declared incomesof corporates and
high-income individuals as well aslarge-scale evasion by them. Responsible for
such evasion are also those who are part of the so-called formal economy and
have been the biggest beneficiaries of the growth of the last twenty-five years.
At the same time, big corporate interests,even as they take great advantage of
‘informality’, also want to expandin some areas like retail trade by
encroaching on and displacing the ‘unorganized’ sector on which so many depend
for their livelihood. They and different kinds of financial interests within
the formal sector also want to gain from shifting many transactions from cash
to non-cash forms. Big corporate interests are also interested in the state
spending on infrastructure that will benefit their profit-making activities but
they do not necessarily want to pay the taxes to finance such expenditure.

The false idea that the entire
responsibility for the black economy and inadequate tax revenues lies on the
‘informal’ and cash using economy, and the myth that excessive use of currency
is the sole problem, has therefore some objective basis in the current
realities of Indian capitalism as is the conception that GST will work wonders
for the Indian economy. These have been in circulation for some time and reflect
in part the ‘rationality’ or outlook of a regime that is deeply and narrowly
committed to advancing large corporate interests and unable to look beyond the
aggressive pursuit of a neo-liberal path. The Prime Minister who announced the
demonetization move also appearing in the advertisements of two private
companies, one issued before and one immediately after the announcement,
reflects that. Translation of that ‘rationality’and the current economic
circumstances into a specific act that many might consider insane, namely
demonetization, was not however inevitable – it perhaps depended in addition on
the current regime having a deeply ingrained authoritarian character and a
leader harbouring ambitions of grandeur. Extreme class bias and the arrogance
of authoritarianism, however, also produces a blindness – in this case about
the role that currency plays in the lives of India’s people and the effects it
will have in them. It is less certain therefore in comparison to many other moves whether demonetization and the political propaganda
linked to it willcarry ‘currency’ with the people.

Surajit Mazumdar is a Professor of Economics in Jawaharlal Nehru University.

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