In late 2016, India's government put in motion a bold experiment in demonetization. In a surprise address to the nation, Prime Minister Narendra Modi declared on Nov. 8 that banknotes in the most widely circulated denominations could no longer be spent and that those possessing the notes had until the end of the year to return them to banks before they became worthless. The move was both politically and economically risky, but the government deemed those risks worth taking, given its goal of downsizing the country's large, cash-heavy informal economy and its campaign against so-called "black money," either counterfeit or illicitly obtained notes that India asserted were aiding the funding of terrorists.
Ten months later, the effects of the demonetization campaign, which involved suddenly withdrawing 86 percent of the physical cash in circulation, are starting to come into focus. Most notably, on Aug. 30, the Reserve Bank of India released its annual report indicating that of the 15.44 trillion rupees ($239.9 billion) in paper currency that was demonetized, 15.28 trillion, or 98.96 percent, of it had been turned in to the country's banks. With the stated primary goal of the exercise having been to attack the black money problem by leaving it stranded and unreturnable, this revelation has been taken by many commentators as proof of the program's failure. In truth, with currency in circulation now having returned to about 85 percent of its previous levels, it is still too early to make such judgments. Demonetization's goals were broad, and until more time passes, its final effects cannot be assessed. Nevertheless, the central bank's data release presents an opportunity to measure the progress that the program has made thus far.
The goals of demonetization, according to the country's Press Information Bureau, were severalfold:
- Strike at the financing of terrorism by flushing out black money and counterfeit currency.
- Narrow the scope of the informal economy to expand the tax base and employment offered by businesses on the books.
- Promote digital payments to make the Indian economy less reliant on cash.
Target: Eliminating Black Money
When Modi announced demonetization, he told the Indian people that the program would assault black money. In theory, by forcing people to return their currency to banks, those who'd obtained large amounts of it through nefarious means would be reluctant or unable to explain how they earned it and avoid the process. Thus, their cash would be left stranded, allowing the government to print new bills to replace this voided black money — and pocketing a tidy seigniorage fee in the process.
This original aim has not been achieved. Before the demonetization push, some estimates had put the unreturnable amount of bills at about 10 percent of the total. Instead, all but 1 percent has been turned in. This means either that there was much less nefarious money in the system than believed or that the holders of black money found a way to return it along with the legitimate cash. The latter explanation is much more likely, partly because the unreturned share of the total is so unfeasibly low. As monetary economist JP Koning has pointed out, when European citizens had to return their cash following the advent of the euro, they were given a decade in which to do it; after that period, the returned currency rate in the eurozone's developed economies was roughly equivalent to that of India after its only two-month demonetization. With India being considerably less organized than its European peers, its enforcement ability considerably weaker and its much tighter deadline, the most reasonable explanation is that Indians effectively found ways around the restrictions.
The upshot of this is that there now probably exists within India's banks large quantities of freshly deposited money that, following investigations over the coming years, could still be exposed as "black." Although it did not find quick success in its fight against black money, the Indian government's longer and more methodical effort may yet root out quantities of ill-gotten gains.
Target: Formalizing the System and Expanding the Tax Base
A secondary goal of the campaign was to bring more Indians under the government's fiscal umbrella. India's informal economy is indeed gargantuan. Tax revenue (including indirect taxes) is estimated to equal just 16.7 percent of its gross domestic product in 2016, compared with 25.4 percent in the United States and 30.3 percent in Japan. As part of the process of returning canceled notes to banks, the government hoped that Indians would enter the formal economy and start paying taxes.
Initially, progress toward this goal appears to be substantial. The government added 9.1 million taxpayers in 2016-17 (the Indian fiscal year runs between Aprils), a remarkable 80 percent increase over the typical annual rise and a marked uptick from the 55.9 million Indians who paid taxes in 2015-16.
Digging a little deeper reveals that these impressive figures may be a little deceptive, however. Demonetization is just one of several policies the Indian government has pursued in an effort to swell the taxpayer ranks, with another being the 2016 Income Disclosure Scheme, which led to substantial increases in transparency and the tax base (with an estimated addition of about $4.5 billion in taxable income). Unfortunately for the tax base, the Income Disclosure Scheme was a one-shot program that will not continue. Thus, after the dust has settled, the tax base gains attributable to demonetization may turn out to be considerably less impressive.
Target: Boosting the Digital Economy
The government's effort to increase participation in the digital economy is certainly linked to the other two goals of demonetization, in that India's giant cash economy makes it harder to pursue criminals and collect taxes. Digital payments create a record of transactions that can be tracked, improving overall transparency and increasing the government's powers of supervision. With cash proving unreliable, especially during the two-month demonetization period when ATMs were running out of notes and lines of people waiting for cash stretched around blocks, the hope was that the public might migrate to novel online payment systems.
Again, at first blush, the results in this sphere were positive. India's largest online payment company, Paytm, reported a sharp percentage increase in overall traffic in the five days after the demonetization announcement, with a substantial increase in money stored in its accounts. This trend continued, and Paytm's valuation jumped 4.7 percent immediately as the company's prospects improved, and in March, its valuation reached $6 billion, with 200 million users of its digital wallet. The growth in digital payment usage is also backed by a study conducted in March by consulting firm MicroSave that found a 69 percent increase in the use of mobile wallets after demonetization. Of the respondents the firm spoke to, 66 percent said they were likely to move to such systems permanently, even after the cash supply returned to normal.
But the picture in this case, as with the tax base, is muddied by separate considerations; within the past month, the digitization drive in India has suffered setbacks in the courts. On Aug. 30, an Indian Supreme Court ruling established privacy as a fundamental right. That finding represents a direct challenge to Aadhaar, India's biometric identity system. Launched in 2009, it has attempted to compile the identifying characteristics, such as fingerprints and iris scans, of its 1.3 billion citizens into one database. The system provides the foundation for India's digitization drive. Indeed, anyone wishing to open a digital account must first enroll in Aadhaar. With the privacy judgment spawning direct challenges to the legality of Aadhaar set to be heard in courts in November, uncertainty now hangs over the entire digitization drive.
The Side Effects, Both Political and Economic
Finally, it is worth considering the unintended effects that might have emerged from the demonetization policy. When it was first announced, there was a wide expectation that it would set back India's short-term economic growth. But 10 months after the fact, no dramatic effect has shown up in official figures. While there has been a slowdown — the economy grew at 5.7 percent during the period from April to June this year, far off the 7.9 percent growth experienced during the same period last year — it seems to broadly track with a slowdown that already had been in progress before demonetization. This suggests the effect may be cyclical rather than related to the policy, although demonetization certainly could have contributed to it. As JPMorgan's chief India economist, Sajjid Chinoy, recently wrote, a wide variety of high-frequency indicators have revealed slowing growth for over a year now.
Meanwhile, in political terms, the move could easily have created problems for the government. The population, both rich and poor, suffered a huge disruption as people were made to stand in line at ATMs for days on end, seemingly at the whim of the government, to obtain the cash they needed for everyday living. But, in fact, demonetization has thus far proved a political boon for Modi's Bharatiya Janata Party (BJP). Poor voters in the key state of Uttar Pradesh appear to have embraced the policy as a great blow struck against their enemies: rich people who were forced to stand in line and dealers in black money. Whatever the reason, the result was a resounding victory for the party in state elections in March. The BJP's position has only strengthened since. In short, whatever the economics, demonetization can broadly be viewed as a political success.