27th May 2024: Demonetisation is the process of removing the rights of certain currencies to be used as legal tender. In this process, the existing currency units are replaced with new ones to counter specific economic challenges. India has witnessed demonetisation three times: in 1946, 1978, and most recently, in 2016. The primary objectives of the 2016 demonetisation were to curb black money, transition towards a cashless economy, control the generation of fake notes, and prevent tax evasion.
Objectives of Demonetisation
On 12th January 1946, the British Government and the RBI Governor of that time, Chintaman Dwarakanath Deshmukh, decided to demonetise the Rs.500, Rs.1,000 and Rs.10,000 notes. Its main aim was to curb the increasing black-market operations, which was a result of WW2.
A few years later, the Morarji Desai government ordered the demonetisation of ₹1,000, ₹5,000, and ₹10,000 notes. It came into effect on 16th January 1978 under the 1978 High Denomination Bank Notes (Demonetization) Ordinance.
On November 8, 2016, Prime Minister Narendra Modi announced a bold and unprecedented move: the demonetisation of all ₹500 and ₹1,000 banknotes. The old ₹500 and ₹1,000 notes were declared invalid, and new ₹500 notes were introduced alongside the newly created ₹2,000 notes, it aimed to:
Curb Black Money: Large amounts of unaccounted money were stored in the form of high-denomination currency notes.
Promote a Cashless Economy: Reduce reliance on cash transactions and promote digital payments.
Control Fake Currency: Eliminate counterfeit notes that were used for illegal activities.
Prevent Tax Evasion: Encourage people to declare their income and assets, thus broadening the tax base.
Advantages of Demonetisation
Reduction in Black Money:
By invalidating ₹500 and ₹1,000 notes, the government aimed to force holders of unaccounted cash to either deposit it in banks, thereby revealing it to tax authorities, or lose its value. This move effectively rendered an estimated ₹3 lakh crore of black money ineffective or brought it into the formal economy.
Curtailment of Fake Currency:
According to the Indian Statistical Institute, approximately ₹400 crore of fake currency was circulating in the economy at any time, with an additional ₹70 crore being added annually. Demonetisation helped in eliminating fake currency as the new notes had advanced security features that were harder to counterfeit.
Increase in Bank Deposits and Higher GDP:
Since 86% of the currency in circulation was in the form of ₹500 and ₹1,000 notes, demonetisation led to a significant increase in bank deposits. By 18th November 2016, the Reserve Bank of India had collected over ₹5.2 trillion. This increased liquidity in banks, potentially boosting the GDP by 0.5% to 1.5%. The State Bank of India alone reported ₹1.27 trillion in new deposits.
Lower Interest Rates:
The surge in bank deposits allowed financial institutions to reduce lending rates, making borrowing cheaper for consumers and businesses. This was expected to stimulate investment and consumption, thereby driving economic growth.
Reduction in Property Prices:
The real estate sector, which had high levels of black money transactions, saw a decline in property prices as the flow of unaccounted cash dried up. This brought property prices closer to their actual circle rates, making real estate more affordable.
Halt Over Hawala Transactions:
Demonetisation dealt a significant blow to hawala rackets, which facilitate illegal money transfers without actual movement of currency. By disrupting these networks, the government aimed to cut off a major channel for money laundering and terror financing.
Financial Inclusion:
The large deposits due to demonetisation enabled banks to extend more services and loans at lower costs, particularly benefiting Jan Dhan accounts, which saw a significant increase in deposits. This move was intended to enhance financial inclusion by integrating more people into the formal banking system.
Reduction in Fiscal Deficit:
By bringing unaccounted income into the tax net, demonetisation increased tax collections. This additional revenue helped the government reduce the fiscal deficit, thereby improving the country’s financial health.
Higher Statutory Liquidity Ratio (SLR):
Increased cash deposits led to a higher demand for government bonds, raising the Statutory Liquidity Ratio. This provided the government with more funds for public spending and investment.
Reduction in Terror Activities in Kashmir:
The lack of funds following demonetisation significantly impacted the insurgency in Kashmir, which was reportedly funded through illicit cash transfers. The disruption of these funding channels led to a temporary halt in unrest and terrorist activities.
Disadvantages of Demonetisation
Initial Public Confusion and Anger:
The sudden announcement led to widespread confusion and anger as people scrambled to exchange old notes. Long queues and chaotic scenes at banks and ATMs were common, leading to significant inconvenience for the public.
High Costs of Implementation:
The process of invalidating old notes and printing new ones involved substantial costs. If these costs outweighed the benefits, the economic rationale for demonetisation could be questioned.
Demonetization has disturbed the bank operations and made the employees to work under unconditional stress in extended working hours of a day. Most banks were unable to provide other banking services while exchanging the banned currency notes.
Impact on Small Businesses and the Informal Sector:
The informal sector, which largely operated on cash, faced severe disruptions. Many small businesses experienced a drop in sales due to the cash crunch, leading to economic hardship for daily wage workers and small entrepreneurs.
Potential for Evasion and Alternative Asset Classes:
Not all black money was held in cash; significant amounts were likely invested in real estate, gold, or other assets. Thus, demonetisation alone could not fully eliminate black money, as individuals could find ways to evade detection.
Short-term Economic Slowdown:
The immediate aftermath of demonetisation saw a slowdown in economic activities. Consumer spending and business investments took a hit, affecting overall economic growth in the short term.
Conclusion
Demonetisation was a bold economic experiment with far-reaching implications for the Indian economy. While it succeeded in bringing a significant amount of unaccounted cash into the banking system and curbing counterfeit currency, it also caused substantial disruption to daily economic activities and affected vulnerable sectors of society. The long-term benefits, such as increased tax revenue and a reduction in illicit activities, must be weighed against the short-term hardships faced by the public.
