India’s demonetization and the future

Opinion by Rhea Karuturi
Dec. 2, 2016, 2:25 a.m.

When I woke up on Nov. 8,  I had a message from my mother — it was a link to an article about how to exchange Indian currency notes now that the Rs. 500 and Rs.1000 notes were no longer legal tender. I didn’t click on the article — I assumed this was the kind of Whatsapp forward that I’m used to getting— the kind that usually start with “Post this as your status so Facebook can’t sell your data …” — and instead started reading the news for the day. And between articles about America’s big election day, I stumbled across articles which ranged from shocked to incredulous to outraged, all saying that Narendra Modi, India’s prime minister, had demonetized the two most common denominations of currency, an estimated 86 percent of cash in circulation, in a country where about 90 percent of transactions happen in cash.

Modi announced that citizens could deposit their money at banks or post offices or had until Dec. 30 to exchange their notes at banks — and that amounts larger than a certain threshold increase in income would require an explanation.

I was dumbstruck — I couldn’t wrap my head around how big of a move this was and all the implications it would have. The change was undertaken to tackle the problem of black money, terrorism and the informal economy that escapes taxation by bringing the cash holdings of citizens into the banking system, where it couldn’t easily avoid detection, and by making the cash that didn’t enter the system essentially useless. And it seemed so simple and bold and brilliant.

But this was happening in India — and I had to ask, could the government really pull it off?

That was a few weeks ago; many have since answered with a definitive no. There are many accusations today that the policy’s intentions weren’t those that were sold to the public — that it was a move to cripple political opponents, to make Modi appear stronger, to inconvenience the middle class while the rich stashed their black money in Swiss accounts. I am willing to start from a position of giving the government the benefit of doubt — at least for now. But that brings its own set of questions that center around not intent, but implementation.

The legs that needed to hold this policy up — government-issued IDs, widespread access to bank accounts, proliferation of banks and ATMs (both supplied with enough new currency and adequately staffed) — were not ignored by the government. Over the last few years, India has made a huge push to issue ID cards — according to the UIDAI, the body charged with issuing government IDs (called Adhaar cards), in 2015, 93 percent of adults in India had an Adhaar card. Another government program, called the Pradhan Mantri Jan Dhan Yojana scheme, launched in 2014, aimed for financial inclusion with the goal of opening a bank account for every household in India. The Jan Dhan scheme did make some huge strides, at least according to their own data, but even while the penetration rates for bank accounts surged, a reported 43 percent remained dormant, with only 39 percent of bank account holders having a debit or an ATM card.  

But as many have pointed out in the wake of this policy, those measures were not enough. Increasing bank account penetration from 35 percent in  2011 to 53 percent in 2014 is incredibly impressive, but that still means that almost half the country doesn’t have access to banking, and a large proportion simply use alternative methods of financing (for example, cooperatives, which are more trusted), and 300 million people don’t have the required government identification.

Further, the policy tried to tackle several problems: the more extreme, like counterfeited currency and terrorism, but also issues like the informal economy and the cash transactions that allow it to exist under the government’s radar, and corruption, which everyday citizens are familiar with. But while on the surface these moves seems to tackle these issues, a closer look reveals that the effects caused by demonetization don’t align as neatly with what the policy states will happen.

Informal Economy

There are two questions at play when considering the informal economy and the policy’s approach to it — one, is the informal economy desirable, and two, is it avoidable in India?

The first depends on what the informal economy comprises — yes, it does contain the black market and can lead to trade of illegal or questionable goods, but it sometimes simply involves farmers or low-wage workers and local rural economies. In those situations, cash transactions are not a method of circumventing the government but rather the only practical means of exchange among those without access to banking, whose livelihoods are small, irregular and/or best suited for an informal setting without regulations.

As The New York Times explains, “Plenty of Indians do use cash transactions to hide their wealth and avoid taxes — less than 3 percent of the population pays income taxes — and the authorities occasionally arrest businesspeople or corrupt officials with currency hoards that can fill trucks. But plenty more people use cash because of habit, poverty or a lack of easy access to banks.”

This explains the disproportionate impact of this policy on the middle and lower wage classes — and it is the derailment of the latter’s lives caused by the demonetization that has caused many to write that the policy is a failure — and others to go so far as to call it a criminal injustice. Forced to stand in long lines at banks and suffocated without the liquidity they need for daily wages and purchases, it is the vast majority of India, which the government wants to help with the recovered black money, who are actually paying the heaviest price for this policy.

But taxing the informal economy is one of the government’s aims. As Ramesh Thakur reports for the Japan Times, “Only 5 percent of Indian workers pay income tax, just 15 percent of the economy is inside the tax net and India’s tax-to-GDP ratio, at 17 percent, is 5 points lower than comparable countries.” Which seems to answer the first question — that an informal economy isn’t desirable, even if it does contain more than illegal trade.

But the second question is harder — because the informal economy in India is estimated to employ 94 percent of India’s labor force and covers large parts of the country, each with varied reasons for being inaccessible to the government’s net of regulation. This gray and black economy is not isolated, either — it is very much interwoven with the white economy, and shocks to one reverberate through the other, and crippling one would necessarily cripple the other. And while the size of this informal economy can shrink, this policy brings into stark question whether the informal economy can end in India, and the adverse effects (a slowdown in GDP growth, for instance or the loss of livelihood for millions) its end would have.


Corruption is simply a part of how things work in Indian bureaucracy — a frustrating, callous, humiliating thing to admit, but nonetheless true. That it is holding India back and is a menace that needs to be solved for the country to develop further is taken for granted. And Modi’s rhetoric implies that although this policy causes disruptions and difficulties, it will be worth it because it will fight corruption.

But it isn’t clear how this policy will hamper corruption — first, because as many experts have pointed out, most black money isn’t held as cash but is converted to assets or transferred overseas. And second, even if money from bribes was held at home in gurney bags, demonetization would have to work perfectly with no loopholes for the rich, clever and/or powerful to navigate through. And third, although through this policy, some money obtained through bribes may now be worth nothing or at least brought into the bank system to undergo scrutiny, in a few weeks (if it hasn’t started already), new bribes will be paid with the new notes. To stop that, the government has to go beyond this policy and tackle the underlying factors that allow corruption to thrive in the Indian economy — it has to have more severe punishments for those asking for and those offering bribes, it has to actually enforce those punishments at a rate that would actually deter people from risking the crime, and it has to address the fact that underpaid, overworked government officials are simply more prone to succumbing to bribes — and it has to change those incentives. It needs to address the structural problems India has that make it an environment where corruption flourishes — the red tape a regular citizen has to navigate with their limited resources and the cultural expectations of what business as usual entails.

As Ruchir Sharma, chief global strategist and head of emerging markets at Morgan Stanley writes, “Scrapping large bills may destroy some hidden wealth today, but the black economy will start regenerating itself tomorrow in the absence of deeper changes in the culture and institutions that foster it, which in turn is a function of a country’s per capita income. Only as a nation gets less poor do corruption, black money and the role of cash decline. There is no shortcut.”

This debate is characterized by those who support the move and those who oppose it. One side is called criminal for implementing the policy, and the other is called anti-nationalistic for questioning it. In talking about demonetization, several economists have weighed in to judge whether this policy will work, but the Economist writes, “The question is not whether the scheme will work but whether the cost of implementing it is worth it” — and I think there is value in both arguments. One approach examines the intent of the policy and whether it was the right economic lever to achieve that end; the other considers what the means to that end entail — and what the real cost of implementation will be.

And that is the question I find hardest to answer: Can you separate the intention of a policy from its implementation — and what does that mean in the context of an underfunded government riddled with corruption and charged with a sprawling population united by their diversity? How do we reconcile Modi’s aspirations for a cashless economy in India with the sheer number of people in the economy leading a hand to mouth existence?

The government’s aspirations for India are important — India is a country that is young and bursting with potential, and we live in an exciting world of digitization and accelerated growth, and nobody wants to be left out.

But the reality of India is important too — and the as Kenneth Rogoff, professor of public policy and economics at Harvard University writes, the long-run gains of demonetization depend on implementation — not intentions, not aspirations, but whether the government can deliver on its promises. It is the article by Larry Summers, the Former US Treasury Secretary and an advocate for demonetization in America and Europe, that really brings this point home: he describes the many implementation errors that made this move fail (e.g. making existing notes invalid instead of stopping the printing of new high denomination notes) and the defining characteristics of the Indian economy that remain unchanged by this policy (like the corruption accepted as a normal business practice, for instance) that are responsible for the problems the government wants to tackle.

When Manmohan Singh, India’s ex-prime minister, known first for his radical economics that saved India in 1991 and later for his weak performance as the leader of a country, stood up in Parliament while debating this policy to say, “Those who say demonetization is good in the long run should recall the quote: ‘In the long run we are all dead,’” I was enormously disappointed. When you are building a country, the long run does matter — and that is why people chose Modi in his landslide victory in 2014. We need big ideas, bold moves and the audacity to hope. But that doesn’t justify this kind of policy, which writes off the suffering of millions as collateral damage when that suffering could so easily be avoided. And while this policy may make the government wary of large changes, what we don’t need is another political era defined by meek bandaids for gaping wounds. What we need from the Modi government is for them to keep dreaming but to do it better: and to do the hard work of making those dreams work with the reality we have.


Contact Rhea Karuturi at rheakaru ‘at’ 

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