Demonetization – The financial surgical strike: impact on Business and

economy
- Kanav Goyal & Nandini Kedia1

ABSTRACT:
An unthought public sector innovation, certainly an historical move was undertaken in the
Indian economy, when on November 8, 2016 the prime minister declared the radical monetary
step of demonetizing the Rs. 500 and Rs. 1000 notes in circulation with new currency of
denomination 500 and 2000 respectively, implying that unit status of Rs. 500 and Rs. 2000 note
as a legal tender was declared invalid. The move was undertaken with a real goal of eradicating
the problem of black money and developing a cashless society, promoting the use of digital
money as people in India are more reliant on cash than any other country on earth. With the
government calling back 84% of its money in circulation, the immediate impact of the move was
certainly drastic, particularly on all the markets based completely on cash transactions.
Notwithstanding, the situation improved with increase in liquidity in the economy through
issuance of new currency and furthermore, by millions of new users coming onto the country’s
digital economic grid by virtual fiat. Different sectors of the economy shall have varying impact
in short run and long run due to this financial surgical strike. Through this paper, we will try
and analyse the impact of this move on availability of credit and the business and economy at
large. And for this purpose, we shall study the impact of demonetization in very short, short and
long run on different sectors. While the move has seen a mixed reaction from people all over the
country, this step is likely to fetch results in long run, yet another question raised by this move
would be whether or not India was ready for this cashless revolution?

KEYWORDS: Demonetization, Digital Money, Cashless Economy

INTRODUCTION
1
IILM Institute for Business and Management, Gurgaon, Haryana
# Demonetization
The etymology of the word demonetization can be credited to the French word- démonetiser
(de+monetiser), meaning depriving (a coin or a precious metal) of its status as money. Thus,
demonetization is a radical step taken by the government in which a currency’s unit status as
a legal tender is declared invalid implying that the series of currency is no longer a valid
currency. A step like demonetization is taken up in any economy whenever there is change in
national currency, replacing the old unit with the new one.

# Demonetization in India

India has undergone the process of demonetization several times and the move of 2016 is not
the first time in India that the legal tender of any currency has been declared as invalid.
Various instances in the past have been seen whereby the currency of India has been changed,
be it in the form of removing old currency or issuing a new denomination. Thus, India is not
new to demonetization. In the past, the country has successfully implemented demonetization
twice and the recent act of 2016 is the third time. Thus, we can categorize demonetization in
following phases:-
 In 1946
 In 1978
 In 2016
 In 1946
Rs 500 and Rs 1000 notes were introduced in 1934 in India and after four years, in 1938,
Rs 10,000 notes came into picture. In 1946, the government decided to remove the Rs.
1000 and Rs. 10,000 notes in circulation. This move did not have much impact as the
currency of such high denomination was not accessed by the common people. Quite a few
number of population only used these notes and thus, the move was not a success and was
later justified as an attempt to contain the volume of banknotes in circulation due to
inflation. However, both the notes were later reintroduced in 1954. Also, an additional
denomination of Rs 5,000 was introduced.
 In 1978
Quite a substantial move at that point of time undertaken by the government was to
demonetize Rs. 1,000, Rs. 5,000 and Rs. 10,000 notes in order to tackle the issue of black
money in the economy. Under the High Denomination Bank Note (Demonetization) Act,
1978, all “high denomination bank notes” ceased to be legal tender after January 16, 1978.
 People possessing the notes were given time till January 24 the same year to exchange the
high denomination bank notes. The after effect of the cause was not a triumph as the
currency of high denomination was barely in circulation unlike the Rs 500 and Rs 1000 as
off today.
 In 2016
Prime minister Mr. Narender Modi on the evening of November 8, 2016 in his address to
the nation, declared Rs 500 and Rs 1000 notes invalid in order to tackle the issue of
parallel economy, counterfeit currency in circulation and terror financing which had taken
deep roots in the country. However, the notes in denomination of Rs 100, Rs 50, Rs 20, Rs
10, Rs 5, Rs 2 and Re 1 and all the coins continue to be legal tender. The step also saw
introduction of new currency notes of Rs 2,000 and Rs 500. The other forms of currency
exchanges i.e. cheques, demand drafts, payments via credit or debit cards did not see any
kind of change. People who possessed the notes of Rs 500 and Rs 1,000 were allowed to
deposit the same in their banks and post office accounts within the stipulated time period
i.e. from November 10 till December 30, 2016. Following, this step, huge crowds could be
witnesses outside ATM’s across the country as people wanted to withdraw the currency of
smaller denomination. While, the step of Indian government to remove 86% of its currency
in circulation was successfully carried out, people however, faced the challenges in
adapting to it as there was no adequate supply of new notes ready to take place of the old
currency. Also, the fact could be stated without any doubt that India is a country which is
more reliant on cash than another country in this world. This, this sudden outbreak of no
liquidity in the market left hundreds of millions of people without any means to engage
economically implying engaging in the activities of buying the things they wanted and
needed. Not only the common man was effect, even myriad businesses were left without
readily available mechanism to buy supplies, pay their staffs and receive payment for their
goods.

# Demonetization around the globe

There are several incidents all around the globe where countries have demonetized their
currencies and introduced new currency. Adoption of a new currency completely depended on
the need of the country. Some of the most commonly discussed about demonetizations are:-

 Europe – When the European Union was formed in 2002, all the countries of the European
Union accepted euro as their currency and phased out their respective currencies. For
 switching to euros, initially, exchange rates for varied national currencies into euros were
fixed and after the introduction of euros, the demonetization of the old national currency
took place. However, in order to assure a smooth transition through demonetization, the
old currencies remained convertible into euros for a fixed period of time.
 Zimbabwe – Zimbabwe used to have a $100,000,000,000,000 note i.e. a hundred trillion
dollar note. In order to combat the hyperinflation recorded at 231,000,000%, the
government demonetized the zimbabwian dollar and solidified the US dollar, Botswana
pula, and South African rand as the country’s legal tender.
 Philippines - In 2015, the nation demonetized its bank notes which had been available for
use for a long time (presented in 1985) with new ones which had just been available for use
since 2010 to avoid falsifying. From January 2017 forward, the old bills will be
demonetized, or will no longer have financial esteem.
 Nigeria – In 1984, during the government of Muhammadu Buhari, demonetization of
Nigeria’s old currency was done and instead a new currency was adopted. The country
hitherto was debt-ridden and inflation hit and consequently, could not take the change well
and collapsed.
 Ghana – In order to tackle tax evasion and empty excess liquidity, in 1982, Ghana
demonetized their 50 cedi’s note to tackle tax evasion and excess liquidity. The economy
turned weak by this move as people of the country started supporting black market and
started investing in physical assets.
 North Korea – In order to banish black market, Kim – Jong II introduced a reform that
knocked off two zeros from the face value of the old currency. This move of 2010 left the
people of Korea with no food and shelter.
 Soviet Union – Mikhail Gorbachdev government in 1991, in the Soviet Union banned the
currency note of ruble 50 and 100 with the aim to end black money in the country and
providing a proper life to common people. The step of the government saw a very wrong
turn and people started doubting the government leading to change in the ruling
government.
 Britain – In 1971, in order to bring uniformity in the currency, pound and pens in
circulation were demonetized and coins of denomination 5 and 10 were introduced. This
policy failed in all other countries except Britain.

Literature Review
Demonetization and its impact on the business and economy at large has been a great topic of
study for a long time. This research paper tries to comprehend analyse the impact of this move
on availability of credit and the business and economy. The idea of selecting this subject
matter has come into existence due to the work of some scholars, which acted as our initiation
point. The scholarly articles by these scholars are the initiation point of our field of study.
Profound gratitude goes to:

Rao, et al., (2016) in their working paper titled “Demonetisation: Impact on the Economy”
have elucidated the impact of demonetisation on availability of credit, spending, level of
activity and government finances. Also, they have argued upon the possibility of the statement
that the cash that would be extinguished from the economy would be “black money” and
hence, should be rightfully extinguished to set right the perverse incentive structure in the
economy.

Deodhar, (2016) in his paper titled “Black Money and Demonetisation” provides an insight to
the various aspects of demonetization. The paper aims to answer the questions such as - What
are the costs of this demonetization? Will it be effective if people can still create new black
money thereafter? Will it increase the GDP? Will it increase inflation? What about tax
revenues? Etc. Also, how the black money would be eradicated has been discussed.

Boggs, (2016) in their research paper titled “The Impact of Demonetization in India” has
mentioned about demonetization in Indian scenario. Clear analysis of demonetisation on key
sectors such as real estate and construction, Automobile, auto ancillary and some other
industries has been discussed.

Kararach, Kadenge, & Guvheya , (2010) in their paper titled “Currency reforms in
Zimbabwe: An analysis of possible currency regimes” have explored various options of
currency regimes that could be adopted in the short and medium term in order to consolidate
economic stabilization and recovery in Zimbabwe. Alsao, the paper’s review of international
experiences of economic crises highlights a number of conditions crucial for a successful
currency reform i.e. the monetary policy reform, fiscal reform, central bank reform, socio
economic convergence, establishment of social safety nets and strong leadership and political
commitment.

Bank, (1998) in its report titled “The currency reform in the Western zones of Germany”
propounded that a radical currency reform was carried out in west germany, which was based
 upon the principle of reducing by nine-tenths the nominal amount of currency, bank deposits
and claims, and a subsequent blocking of half of the reduced volume of deposits. Also, in the
country, following this currency reform, the taxation system was modified and a large number
of price controls and rationing measures abolished. The overall impact of changes in the
currency reforms have been analyzed.

Ramdurg & CS, (2016) in their paper titled “Demonetization: Redefining Indian economy”
have made an attempt to assess how the tool of demonetization can be used to eradicate
parallel economy. Also, lessons from history guide us how to redefine economy of country by
overcoming the earlier cause for failure. This paper aims to discuss the short term and long
term benefits of demonetization which certainly override the short term challenges.

Objectives of the study

 To know about demonetization and its need.

 To study the general impact of demonetization on the economy and impact on the key sectors
in short and long run.
 To study the change in mode of payment and spending behavior of the consumer.

Methodology of study

This study has been conducted on basis of following methodology:-

 Selection of Industries – The key sectors of the economy have been considered for study
purpose i.e. automobile, real estate, agriculture, banks and FMCG.
 Time Period of the study – The impact of demonetization in short and long run has been
analyzed.

Need for Demonetization

Demonetization has been carried out by various nations around the globe. While the fact of
replacing an old currency with the new currency remains same, the interesting part is to know
about the reasons for adopting demonetization. For instance, India carried out demonetization
to fight the menace of black money, Zimbabwe undertook the step to fight the problem of
inflation. Thus, countries have different grounds to commence the step of demonetization.
India, being a cash based society has 70% of its transactions in form of cash. Also, 80% of the
population account for informal sector, which contribute to around 45% to our GDP (Gross
 Domestic Product). The currency in circulation ratio for India is also the higher, when
compared to other countries around the globe.

Volume of currency notes Value of currency notes

Value of
Value in crore % of all % of currency
Denomination Denomination Rupee in
pieces currency notes value
crore
2 and 5 1,162.6 12.88% 2 and 5 4,500 0.27%
10 3,201.5 35.47% 10 32,000 1.95%
20 492.4 5.45% 20 9,800 0.60%
50 389.0 4.31% 50 19,400 1.18%
100 1,577.8 17.48% 100 1,57,800 9.61%
47.85
500 1,570.7 17.40% 500 7,85,400
%
24% 86%
38.54
1000 632.6 7.01% 1000 6,32,600
%
Total 9,026.6 100% Total 16,41,500 100%

Source: Information published in Business line daily newspaper dated 17.11.2016

From above table, it is clearly evident that Rs 500 and Rs 1000 notes are 24% of the volume
in circulation, but account for 86% of value in circulation. Thus, the Indian government aimed
to withdraw Rs 14, 18,000 crores by demonetizing 2,203.3 crores currency notes of Rs 500
and Rs 1000. The fact about India that out of its total population, only 2.5 crore people file
income tax and that too many with nil tax, arising the need to widen the tax net. India’s tax to
GDP ratio also stands lowest in the world i.e. around 10.6% which is equal to African
countries. Thus, the decision to demonetize the old denomination was a good solution to these
issues. Notwithstanding, one of the most important reason for demonetization was to remove
the counterfeit currency in circulation. It has been estimated that around Rs 400 odd crore is
in circulation, predominantly in Rs 500 notes. Thus, some of reasons due to which Indian
government decided to demonetize Rs 500 and Rs 1000 notes were:-
 To fight the menace of black money and attack the black money holders.
 For death knelling the fake currency racket (as most of the counterfeit currency was in the
form of Rs. 500 and Rs 1000 notes only).
 To put an end to terrorist funding, as huge sums of money in the form of hard cash was
used to fund Islamic terrorists and Naxalites.
 To promote transparency by promoting digital money and online transactions and
strengthening the power of financial intelligence unit.
 For moving towards a cashless economy, by reducing the proportion of hard cash in the
economy.
 To put an end to the hawala transactions carried out using Rs 500 and Rs 1000 notes.

General Impact
The impact of demonetization on India can be seen in both the ways i.e. benefitting the
economy at large and creating unrest among people. Following affects could take place due to
demonetization:-
 Cash crunch leading to decreased demand
The step of demonetization has resulted in significant decrease in liquidity in short term,
which is likely to ease over time with circulation of new currency notes. Also, there has
been a sharp decline in the availability of disposable income with the people, affected
their spending patterns and consumption trends in the economy in short run. The demand
for these particular areas is likely to be impacted the most, owing to the fact that
significant amount of transactions in these sectors involved cash:
 Consumer goods
 Real Estate and Property
 Gold and Luxury goods
 Automobiles (only to a certain limit)
 Significant increase in alternative payment methods
With decrease in liquidity, the cash transactions have been impacted and people have
started using alternative payment methods such as e-wallets, online transactions using e
banking, debit and credit cards etc. For instance, since the announcement of
demonetization, people due to cash crunch started moving to cashless payments through
Paytm. Within 12 days of demonetization taking place, Paytm witnessed over 7 million
transactions worth Rs 120 crore a day. The wallet is moving four months ahead of its
target and has crossed $5 billion Gross Merchandise Value (GMV).
 Benefits to government department
Demonetization has increased the revenue for electricity department of the government.
Earlier, cities used to struggle to collect Rs 5 crore electricity bills, but post this step, Rs
15 crore electricity bills have started being collected. All the people, whether poor,
middle class or high class are forced to pay their dues.
 No practice of donations to get admissions in schools
 With this financial surgical strike, the practice of donations will come to an end. Poor and
middle class people were forced to give away their white money as black for securing
admission of their kids to schools. This practice is likely to stop post this step.
 Effect on the prices
Due to moderation of demand, the price level is expected to be lowered. For instance, for
real estate and property, if we consider sale of properties as an element, the major part of
the transaction involved dealing in cash rather than cheques or bank transfers and thus, a
decline in the prices could be seen as people do not have sufficient money to pay much.
 Create room for further monetary accommodation
With the structural moderation in the currency in circulation, there are chances for RBI to
ease the monetary policy rate further. RBI may ease another 100 bps in this year.
 Financial inculsion via Jan Dhan
The share of the accounts opened under Jan Dhan, out of the total deposit base of the
banking system has remained under 1%. With the move of demonetization, a cash deposit
in these accounts is likely to get a push to around 43% of the accounts, which have
remained dormant. Moreover, this move will help in inculcating the banking habits
amongst people, who were not aware of the banking system, or rather the unbanked
population in the country.
The macro variables would be largely affected due to these changes and thus, some other
impacts of demonetization are:
 Impact in short run
Increased investment in the economy will lead to increase in the demand for capital
goods. Increased demand will lead to increased income in the economy. The sectors,
operating with excess production capacity will be able to meet the demand, but the
sectors with which will not be able to meet the expanded demand, will lead to increased
prices. Thus, in short run, inflation could be expected. This would hold true for sectors
like agriculture, which do not operate with excessive capacity.
 Impact on GDP and employment in long run
This financial surgical strike is likely to affect the money supply in the economy. This
can be looked upon in two ways; the first one being the cash which was used as a medium
of exchange would be extinguished, leading to compression in incomes, employment and
consumption in the economy. While, the replica effect would be of the cash that is being
partially replaced in the system. This would lead to expansion in the potential credit
 creation. When there will be demand for credit, the potential credit will realize into actual
credit and, if it assumed that out of the credit realized, a part is for productive purpose,
and then the investment in the economy will expand, leading to increase in GDP and
employment.
 Impact on balance of payment
Imports for any country are related to the size of the economy. If the step of
demonetization leads to increased GDP, a rise in imports can also be expected, but the
impact on exports cannot be ascertained. Thus, the balance of payment could worsen,
which would have an impact on value of rupee in the international market. The value of
rupee is likely to depreciate.

The following impact would happen, only when the expansion in credit is materialized.
However, we cannot assume this and thus, if the potential credit is not equal to the actual
demand of credit, it would further depress the factors driving investments. The first
consequence of this would be a fall in the interest rates in the economy as banks will have
more lending capacity. The firms with outstanding debt will have lower interest liabilities and
thus, we can see improved balance sheets. If the demand is compressed, a decline in imports
is expected, leading to favorable BOP and appreciation of Indian currency.

Impact on Key sectors

With demonetization in action, a cash crunch in the economy, almost all the businesses have
seen a setback. The small and medium scale business has been hit hard as they were highly
dependent on cash transactions. Vendors like the sabjiwala, chaivala and other small vendors
had to face a lot of problem during the initial phase of demonetization. Although, the situation
has improved now, by a large number of vendors accepting digital wallets, but yet not all.
Some of the key sectors impacted post demonetization are:
 Agriculture and related sectors
Agriculture is a sector which sees high cash transactions and thus, the near term impact
on this sector can be seen till liquidity is infused in rural areas. There could be delay in
payments due to temporary shortage of funds in short term. But, with ease in liquidity and
cashless transactions, the fundamentals would be driven by long term drivers of normal
monsoons and positive traction.
 Auto and auto ancillaries
 Two wheelers: The percentage of cash transactions being high in this segment, could
lead to low purchases. However, demand may pick up by overall growth in consumption
on rural as well as urban side.
Passenger vehicles: During the month of November and December, a seasonal
slowdown was seen. The same could get exaggerated with expectation of rate cuts in the
economy. However, most of the purchases in this segment are financed through loans; the
low demand would be a temporary phenomenon and would recover.
Commercial Vehicles: This sector has been under pressure in recent times and slackness
has been seen in this sector. However, this slowdown may also be short lived and demand
may pick up, led by pre-buying in response to changes in emission norms as well as a
pickup in the overall economic activity.
 Consumption related sectors like consumer durables, FMCG etc.
In the near term, this sector saw a reduced demand by people as most of the transactions
were based on cash. But as people will accept the cashless platforms, the demand will
tend to recover making the near term affect neutral. In long term, the demand may tend to
shift from unorganized to organized players.
 Real Estate
The fact about this sector remains that the land parcels are usually paid in cash. With, the
restriction on cash transactions, the land prices will tend to fall. Cities where speculative
buying is high will certainly see demand under pressure. The overall demand will also
decline. For the long term, as prices will correct, the market can see an expansion in term
of demand as affordability increases. Long term growth in the sector could be seen by
increased transparency, lower incidence of speculation and entry of genuine buyers.
 Building materials, metals, cements etc.
In the near term, a slowdown may be seen due to high dependence on real estate.
Overtime, as the demand would improve as real estate sector will see improvement.
Organized players would see an expansion in market share on the back of shift in
demand.

 BFSI
Banks: The deposit base rise would allow banks to lower the blended cost of funds.
There will improved transmission by the new regime of MCLR immediately taking into
 account the lower costs. The digital wallet providers would benefit both in terms of value
and volume.
NBFC: Companies like gold financing companies, microfinance institutes etc. in short
term would see a negative impact as they make disbursements in cash or do most of the
collections in cash. However, the pain would ease off with companies migrating to
cashless business models.
NBFC lending against property (LAP): From near to medium term, this segment is
likely to face severe pressure due to fall in property prices combined with longer time for
liquidating properties.

Change in Mode of payment and spending behavior

In the modern society, a consumer has many substitutes available for cash ranging from debit
cards, credit cards, mobile wallets etc. and the growing literature points out that as the
consumer move towards other instruments than cash, his/her spending behavior tends to
change. If we separate the extent to which a purchase is done and the payment made from
resources in time, people may overspend as they will not perceive a sense of separation from
money at the time of incurring the expenditure. Also, it is believed that people feel the pain of
payment depending on the tangibility of the outflow. Budget constraint is yet another part
affecting the consumer behavior. While it is believed that cash in hand limits one’s ability to
spend, a debit card expands it to amount available in the account and a credit card further
expands the consumer’s capacity to spend by including future earnings as well. Thus, with the
step of demonetization, the cash in hand with people will tend to shrink and India will move
towards a cashless economy promoting the use of mobile wallets and cards. Thus, if we
categorize the features of payment system, it would be:-

Payment Salience of Salience of Temporal Temporal

Transparency
Mechanism form amount Separation Orientation

No, do not Perception of

Cash Very high High High
exist present-present

Perception of
Cheques Medium High High Low present-present/fut
ure
 Credit Perception of
Medium Medium Medium High
card present-future

No, do not Perception of

Debit card Medium Medium Medium
exist present-present

Perception of
Digital
Medium Medium Medium High present-present/fut
wallet
ure
Source: Braga et al. (2013)

Thus, we can say that when a consumer uses debit card, the level of consumption is high and
with the use of credit cards, the effect is more pronounced. Spending through credit cards also
increases the spending on non-essentials and an increased debt. With demonetization and
people moving towards digital money, there would be long term effect on the economy,
budgets, lifestyles and priority of agents in the economy. The financial system could move
towards a crisis, if not suitably managed, when the consumer trend will tend to increase. And
when, the consumer debt would increase, at the same time the savings in the economy will be
lowered, the investment in the domestic economy will certainly see a setback.

Conclusion
It could be thus said that in a single masterstroke, the government has attempted to tackle
three malaises currently plaguing the economy – a parallel economy, counterfeit currency in
circulation and terror financing. This step will add to investor appeal of the economy over the
next two – three years, with improvement in India’s position on transparency and corruption
in the global stage. While, people will have to struggle a bit in the short run, the move is likely
to benefit the country in long run. Demonetization is usually followed by remonetization. The
government of India has already introduced the RS 2, 00 and Rs 500 notes, but liquidity could
not be met and thus, the focus has to be on popularizing e-banking and e-commerce. So, we
can say that India is currently in the middle of an all-out movement to modernize the way
things are paid for. While, Modi’s demonetization initiative has turned out as a boon for
India’s e payment providers, some sectors of the economy, like real estate, gold and jewellery
have been affected but on the whole, we can say that this change would lead to a more
inclusive society in the future.

References
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