Unbundling Demonetisation

More often than not, we judge policy measures through the lens of our political affiliations. This creates a din of confirmation biases and loud proclamations which ignore trade-offs and opportunity costs. Through this article, I wish to objectively break down demonetisation and put it under a simple costs-versus-benefits scanner. For a policy reform to be considered valuable, there must be a significant net benefit from it.

For the sake of this analysis, I am going to ignore the questionable implementation of this measure; though even a good policy with bad implementation deserves criticism. We must remember that countering black money and transitioning to a cashless economy are not easy tasks. There are bound to be hiccups and a lot of the logistical problems were perhaps unavoidable, as we can gauge from the various communications made by the government and the NITI Aayog (including this interview)

For the 50 day window ending 30 December, The Centre for Monitoring Indian Economy (CMIE), an independent think tank, has made the following estimates to calculate the cost of demonetisation: (Source)

  • Rs 168 billion in printing, transporting and circulating the new currency.
  • Rs 150 billion in wages foregone by households waiting in queues to get new notes.
  • Rs 351 billion in costs incurred by banks, by foregoing their other sources of revenues to exchange cash
  • Rs 615 billion by business enterprises hit by diminished demand from an illiquid consumer base

Intangibly, there was a massive cost of toil and inconvenience faced by the public. The overall GDP is slated to slow down by anywhere between 0.5% to 2% for 2017 (by various proclaimers) or in money terms between Rs 75,000 crore and 3,00,000 crore. Though to be fair, this last estimate may be overstated as the cash crunch might just be a short term problem. Further, now that commercial banks have heavier chests of deposits, we can expect to see increased money availability in the economy through the money multiplier effect in the medium term. Despite this, even a short term jolt to the informal sector can become insurmountable for many in that sector, who may not survive to see this medium term easing. However, most international agencies (WB, IMF included) have lowered India’s growth projections for 2017.

These costs are undeniably large and only a freakishly large set of benefits can outdo them.

The benefits of a policy measure must be judged as per a) the worth of its objectives, and b) the capacity of the policy to meet those objectives. There were three intended objectives as follows:

1) Eradicating Black Money

a) Demonetisation only targets the existing stock of black money held in cash. This is much narrower than the actual quantum of black money that might have been:

  • invested into fixed assets like gold and real estate
  • stashed in overseas banks including the infamous Swiss banks
  • already laundered and made white in the system

It also does nothing to prevent the regeneration of black money in future, thereby making it a temporary attack, at best.

While it is true that the government has and will initiate many more reforms to deal with the other aspects, demonetisation by itself doesn’t seem to have taken a very large objective on its plate. Maybe we could have only had those other reforms sans the costly demonetisation?

b) If we dig down further, it appears that demonetisation might not be able to achieve even this narrow objective. According to various estimates (eg Indian Express) close to 95% of the currency notes in circulation have been deposited back into the banking system. Though this, itself, is widely misbelieved to be a failure of the policy, the Modi government and even economists like Dr Jagdish Bhagwati have told us that just because the money has been deposited back does not make the money clean. These deposits will be scrutinised by the Income Tax Authorities and taxed at 50% plus 25% as loan under the PMGKY (and a 100% de facto tax on the money that remains undeposited). While this is true, there is considerable reason to undermine the Income Tax Authority’s ability to actually retrieve this tax:

  • “390,000 direct tax cases are pending across various forums and an internal committee has suggested that the department should reduce scrutiny to give more attention to litigation management.” : Mint
  • “Sudhir Chandra, a former chairperson of the Central Board of Direct Taxes, has told The Hindu (December 19) that if even 1% of the country’s 450 million accounts are scrutinised it means investigating 4.5 million in one year. Given that the CBDT scrutinises 300,000 annually this is a 15-fold jump. Do we have the trained manpower for this 1,400% increase?” :HT

The same HT article goes on to say that “The process of scrutinising so many accounts could unleash another inspector-raid raj. That means harassment, intrusion and vengeful scrutiny. It also opens the door to extortion, corruption and bribery.” And considering the Indian bureaucracy’s reputation, this situation is not hard to imagine.

2) Transitioning to a cashless society

a) There is no doubt over the importance of this objective. It is imperative for India to reduce its cash to GDP ratio of 12%. Cash exists in a bearer notes which cannot be linked to a source by itself and does not earn an interest while also being unavailable for investments if stored as surplus.

b) There are reasons to believe that we may not actually become cashless:

  • Digital payments including wallets come with a transaction cost (the revenue source for the payment platform) These costs will over time be transferred by the sellers to the customer. The layman is more likely to be perturbed by this explicit extra cost than the implicit cost of money (of bank interest forgone and the other disadvantages of cash), as he is used to anyway. Therefore, the customers are likely to choose the ‘free’ cash over the digital modes while making payments. The slight uptick we see in digital payments may not be sustainable and might just have been a case of ‘being asked to choose any electron in a hydrogen atom’ as Sheldon Cooper would say. [Edit: This report was published in the Mint on 25Jan: Mint, further proving my above prediction.]
  • The government has been proactive in trying to ramp up the digital payment infrastructure with new applications, financial literacy drives and other incentives. But the simple reality is that much of our country doesn’t have smart phones or access to the banking system. A lot of our rural regions don’t even have reliable electricity to begin with, to power digital payments. As much as the government wants to deny it, there is enough evidence that we are not ready for a cashless society.

A society should become cashless gradually, in a phased-out manner; perhaps by starting from the urban areas and targeting a few sectors at a time. An abrupt, pervasive move to cashlessness is extremely difficult to make happen.

It is also to be seen whether the government remonetises the entire volume of the demonetised notes or leaves a gap to actually reduce the 12% cash to GDP rate. If the former happens, it might again weaken the move to cashless.

Though on the good side, we must realise that apart from infrastructure, a behavioural change is also extremely important to make people go cashless. Demonetisation has done well to this end:  a country which only used debit cards to withdraw money from ATMs has started discussing and experiencing a cashless system. This has created a valuable short window to cement this behavioural change. Had this window been supported with a sturdy plank of infrastructure, we could have been well on our way-out of this room of cash.

Also, the Union Budget 2017-18 has announced significant measures to encourage a move to a digital economy which show good promise; including capping allowed cash payment size to 3 Lakhs,  one of my pre-budget wishes for the 2016-17 Budget: Budget 2016-17: What to look forward to?

3) Counterfeit Currency

a) It should be understood that the objective of demonetisation cannot be to eliminate the existing stock of counterfeit currency. The producer of this fake currency has already enjoyed its artificial purchasing power and the notes are now in circulation. The objective is to prevent future flows of counterfeit currency. Further, it is known that the total value of counterfeit currency was only modest in our economy. Therefore, the true objective was to prevent the source (terrorists, Kashmiri insurgents etc) from functioning.

b) It is undeniable that such a prevention of future flows will be temporary unless demonetisation is complemented with other structural changes. The government claims that the new currency will be extremely hard to counterfeit and therefore bust the terrorist activities that are run on fake notes. Even if we were to believe that would happen, only a temporary reduction in terrorist activities is perhaps not as massive a benefit as one would hope for.

We can already see newspaper reports coming in: Three held with 18L worth fake currencyFake notes have 50% of the security features. If these reports have started coming in just 3-4 months after demonetisation, one cannot help but wonder how long this stated goal of countering terrorism will hold good.

One less discussed advantage of demonetisation has been the increase in deposits with banks. This can augment the dim lending activity of banks suffering from the NPA crisis and potentially spur private investments in our country -the sector that has been on a decline for long. This stronger money-multiplier effect (already mentioned before) can help boost growth in a sustained way.


To me, the costs of demonetisation far outweigh the benefits. Supporters often claim demonetisation will bring long term benefits at short term costs. Though in the light of the above analysis, the benefits appear short-termed while it seems the the pain of the costs will linger on.

To stay updated with what I write, follow my blog by tapping ‘follow’ at the right margin (for PC) or the bottom (for Smartphone). I’d love to hear your views and reviews on my article in the comments. Thank you for your time!


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