Impact of Demonetisation in India:

Cash lubricates India. For the simple reason that 20% of Indians don’t have a bank
account. Even if they do, not everyone has a smartphone to dabble in digital
transactions. Millions of people get paid for their labour in cash. Then they go out
and use the cash to buy things. The end result — Over 50% of transactions happen
via cash.

And the ones who regulate this cash? The Reserve Bank of India. They’re the
central authority on all things money. They make decisions on money printing and
the types of denominations —Should you have more ₹100 notes or ₹500 notes?
Stuff like that.

But on 8th November 2016, the Indian government decided to play the role of money
manager. It took matters into its own hands. At 8 pm, Prime Minister Narendra Modi
appeared on national television and made a shocking announcement. All the ₹500
and ₹1,000 notes in people’s wallets and cupboards would be ‘demonetised’. It
would become worthless overnight.

You remember that vividly, don’t you?

That meant 86% of this cash would suddenly disappear from the system. And we
were only given a few weeks to visit the bank and exchange the old notes for new
ones.

It was a mess. ATMs weren’t configured to dole out the newly introduced ₹2,000
notes. And people spent hours and hours just queueing up outside banks and ATMs
to deposit old notes or get new ones. Daily wage labourers lost working days and
money. It was hell.

People were not happy. They felt that the RBI’s role as a money manager was being
diluted. So a few folks decided to go to the Supreme Court and ask the law whether
demonetisation was legally valid. Their contention was that the RBI is the key
decision-maker when it comes to money matters. So how could the government
unilaterally make a decision to demonetise currency?

The Supreme Court heard both sides of the argument. They said, “Hey, we aren’t the
authorities on whether it was a smart economic decision. But we will tell you whether
it broke the rule of law.” And 6 years after the first petition was filed questioning
demonetisation’s validity, the judges slammed the gavel and said, “Yes,
demonetisation is legal!”

The judges are convinced that even if it was the government that proposed the idea,
no one forced the RBI to agree. The RBI had full autonomy. Also, the government
spent 6 months discussing this idea with the folks at the central bank. And the RBI
Board even approved it. So there wasn’t anything wrong.

But here’s something interesting. Dr Raghuram Rajan who stepped down as the RBI
Governor in September 2016 wrote something in his book I Do What I Do: “At no
point during my term was the RBI asked to make a decision on demonetisation.” The
6 months of consultation with the RBI should’ve overlapped during his tenure, no?
So make of that what you will!

Anyway, not all judges were in agreement. One of them disagreed.

She pointed out a problem. If you look at Section 26(2) of the RBI rulebook, it clearly
says that any demonetisation exercise has to be initiated by the RBI. Not the central
government. And so the honourable judge wrote a dissenting opinion.

Also, according to official records, the RBI board didn’t even have time to think
through this idea. They were told about demonetisation only on 7th November. They
had just 24 hours or less to think about the ramifications of such a momentous
decision.

Anyway, a lone dissenting voice cannot change the verdict. The majority of judges
say that demonetisation was legal and that settles the matter.

But maybe now is also a good time to evaluate the economic impact of
demonetisation.

See, the primary goal of demonetisation was to fight black money. The government
was convinced that people were hoarding high-value cash. These were the black
money crorepatis. Some estimates even pegged the black money economy to be
20% of India’s GDP. That means it was worth a staggering $400 billion!!!

So the government thought that if they could declare all the legal cash invalid, it
would destroy this illicit wealth. After all, if these folks tried to exchange their
boatloads of black money notes at the bank, the bank would raise a red flag. And the
government would know. They could raise questions and even put people behind
bars.

And the entire thing had to be done very secretively. Because if you’re trying to
stamp out black money, you can’t involve thousands of people in the scheme.
Someone will let it slip and let the cat out of the bag. The black money hoarders
would’ve had plenty of time to stash away their ill-gotten gains.

But here’s the thing. The calculations went wrong…

Look at it this way. If 20–30% of the ₹15.4 trillion worth of demonetised notes were
black money, no one would return it to the RBI. People would simply have to burn it
or get rid of it because it was worthless. Depositing it would be dangerous. But at the
end of it all, 99% of the money was actually deposited in banks. It was white money!

Apparently, the people with illicit money didn’t simply sit on a lot of ₹500 and ₹1000
notes. They’d already stashed it away in real estate and jewellery.

And did it kill the black money economy?

Not quite. People just went about their shady dealings again. They used the new
₹500 and ₹2,000 notes for their nefarious schemes. The black money economy
picked up. The circulation of fake notes zoomed too.

The other idea of demonetisation was that it would help us become a cashless
economy. But as we pointed out at the start, 50% of transactions are still in cash.

Before demonetisation, the Currency-in-Circulation to GDP ratio stood at 12%.

Immediately after that, it dropped to 8%. By March 2020 (right before the pandemic),
it was back at 12% again. And when the RBI ran a survey in 2018 and 2019, they
found that most people still preferred cash payments for regular expenses.
Especially for small-value transactions up to ₹500. Mind you, the survey covered big
cities like Delhi and Bengaluru as well. Elsewhere, in smaller cities, 90% of e-
commerce transactions depended on cash on delivery for payments. And India’s
informal economy chugs on cash alone. Granted demonetisation may have
expedited digital adoption, but it’s safe to say that the government could have
pursued this measure without shocking the system.

And the worst part? The economy slowed down by at least 2% after demonetisation.
There wasn’t enough cash to support transactions and the GDP sputtered.

So yeah, while the government probably intended to fix a system using a well-
intentioned scheme, the damage was considerable.

In summary, Demonetisation  is  legally valid, but perhaps not as economically sound.