The debacle of demonetisation

On November 8, 2016, the Prime Minister announced that from midnight, ₹500 and ₹1,000 notes would no longer be legal tender. Though Indians were given the opportunity of redeeming the full value of their money held in this form, they could do so only by depositing the notes in a bank or Post Office savings account. The total value of the currency affected by this move, henceforth referred to as demonetisation, was 85%. A former U.S. Secretary of the Treasury described it as among the “most sweeping change in currency policy that has occurred anywhere in the world in decades”. With five years’ experience, we are now in a position to give an unqualified verdict on its consequences.

Changing goalposts

The original argument given for demonetisation was that it would extinguish unaccounted or ‘black’ money. The presumption underlying this was that with unaccounted income inevitably held as cash, owners of these hoards would be hesitant to turn them into banks as they would have to explain the source. When it was pointed out that unaccounted income is very likely to have been converted into real assets or transferred overseas, the government shifted the narrative. It then explained that the move was meant to get the economy to run on ‘less cash’. Finally, it strongly asserted that the move would incentivise direct tax payment and this would raise the government’s revenues sufficiently to allow for greater public investment and the provision of more public services.

The Reserve Bank of India’s Annual Report of 2019 settled the first issue conclusively when it reported that approximately 99% of the affected money supply was deposited into accounts with commercial banks. So, the existence of black money hoards may have been exaggerated, to put it mildly, even though this does not imply that all earnings were being declared to the income tax authorities.

What about the predicted move towards less cash? Well, the ratio of currency with the public to national income has, at 11.5%, remarkably remained the same from 2015-16 onwards. It seems money remains a chosen medium of exchange for Indians, even if purchases are increasingly being made online. Any independent economist could have pointed out to the government that in an economy where a large section of the population has little income to save, cash is likely to stay as a medium of exchange for some time. After all, electronic payments other than those based on credit cards draw upon prior savings. All this is besides the point, however, and misses the how disingenuous the official narrative was. If the idea was to make the population use less cash, there was no need for the secrecy implicit in the hurried announcement of demonetisation. It could have been simply achieved by amendment of the Income Tax Act requiring all large-value transactions to be made by cheque or electronic means.

Finally, we come to the claim that demonetisation would lead to an increase in direct tax payments. Why this would be so was never spelt out, but the data can settle this matter conclusively. We find that the ratio of direct tax collections to the national income rose marginally in 2016-17, but higher rates had been achieved earlier. It continued to rise marginally for two more years, but this cannot confidently be attributed to demonetisation alone. The Goods and Services Tax introduced in 2017 may have nudged potential income tax assesses to comply with the law due to the surveillance that came into force. We can see in the Finance Ministry’s latest ‘Budget at a Glance’ that the trend of a rising direct tax to national income ratio came to an end in 2019-20, and is now lower than it was at the beginning of the decade.

Reversing growth acceleration

With not a single one of the claims made for it having materialised, it may seem that there cannot be a more stinging assessment of demonetisation, but there is worse to come. In 2016-17, India’s economy did register a slight increase in the rate of growth. This may appear to validate the action, but it does not. It is explained by the fact that the growth of the agricultural sector registered a positive swing of over 7% that year. As agricultural yield is weather related, it is independent of economic conditions in the short term. But in the other sectors of the economy, production could have been held back by the cash crunch engineered by demonetisation, thus slowing expansion. We see this in the manufacturing data, with growth slowing by about a third immediately. Nevertheless, growth of the overall economy did not slow in 2016-17 as much of the services sector held out. This was to come the next year, with annual growth slowing continuously ever since. So, this is something demonetisation did achieve. It reversed a growth acceleration that had been in place for at least two years when the Modi government took over in 2014 and had continued till it met the gleefully named ‘surgical strike’.

Imposing hardship

Numbers cannot, however, capture the hardship and insecurity that were so casually imposed on the population by the move. The country was thrown into utter chaos with people trying to change their hard-earned small cash savings in banks that were utterly unprepared for the task. There was an acute shortage of currency notes for at least a couple of months. The supply chain for farm produce was severely disrupted but a history of informal credit meant that it did not die out entirely. Indeed, India was bailed out by the traditional practices of its business communities, even as the government was ostensibly goading it into modernity.

Vladimir Lenin reportedly said, “the best way to destroy the capitalist system [is] to debauch the currency.” In one of the ironies of history, a whole century later, a government committed to capitalism in all its forms attempted precisely that. But demonetisation was not just a flawed economic policy move. Economic policies must not only be sound, they must also be ethically grounded. While it may have been within the government’s constitutional powers to implement demonetisation, on an ethical conception of powers it was a moral failure. Perhaps not since Muhammad-bin-Tughlaq have the people of this country been forced to endure as much by the state. The difference is that today India is a democracy.