India’s demonetization a fascinating case study of cash-reform shock therapy

india cash
Credit: Ajayptp / Shutterstock, Inc.

I expect that most of you will by now have read a fair bit about the (to my mind) fabulous living monetary experiment that is India. Obviously, I feel sorry for people who have been (to put it mildly) inconvenienced by the chaos caused by the removal of 85% of the cash “in circulation” in the country, but as a student of monetary history and the interaction between technology and economics, it is absolutely fascinating to look at what is happening. I’m sure it will be a case study for years to come, and who knows what the long-term impact will be, but I couldn’t wait and I couldn’t resist blogging. So let’s start at the beginning…

Indian Prime Minister Narendra Modi has announced that the existing 500 and 1,000 rupee banknotes will be withdrawn from the financial system overnight. The surprise move is part of a crackdown on corruption and illegal cash holdings, he said in a nationwide address on television.

From India scraps 500 and 1,000 rupee bank notes overnight – BBC News

I saw some television reports of aggrieved and panicked Indians who were unable to get any cash and since much of the economy is cash-based, worrying about a slowdown in economic activity. It’s a bit of shock to go to the bank and discover it is closed. When the banks re-opened, it was with new money. Or at least it would have been with new money, had replacement been produced and distributed beforehand.

On November 8 evening, Reserve Bank of India governor Urijit Patel and senior government officials unveiled the new currency note of Rs 2000 and redesigned Rs 500 note.

From New Rs 2000 note to be introduced in India after banning old Rs 500 & 1000 notes: Pictures of 8 best looking currency notes across the globe –

The result was pandemonium. People went to ATMs to try to obtain new bills only find that there were none to be had. Rich people started paying poor people to stand in line for them to get money. I even saw a photo of people praying to a garlanded ATM! India is a big country and the ATM vendors had no more warning of the change than anyone else, so as you can imagine the planning and logistics were complex. The ATM operators were as non-plussed as the general public by the sudden change.

“Re-configurations takes time so it has to be done one by one. Things should be normal in ten days. You have to understand there are 2 lakh ATMs in the country but there are only three to four vendors.”

From Just 35,000 personnel to replenish ₹16 lakh crore in ATMs | business-news | Hindustan Times

The net result of all of this was that the country ran out of money. Literally. There was no money available for commercial transactions. So to Indians, it really was a big deal and a major disruption.

So why was this done? There were two explicit reasons given for the demonetisation. One was that it was an attack on terrorist funding, and the second was that it was an attack on the black economy. I don’t know enough about terrorist financing in India to comment on the efficacy of the move, but it seemed to target counterfeiting operations in Pakistan.

It disrupts the production of FICN in Pakistan, and makes redundant existing stocks of fake currency with a vast network of terror funders-the hawala traders and money launderers. “The phaseout of these notes is a double whammy for Pakistan,” says Colonel Vivek Chadha of the Institute of Defence Studies and Analyses, Delhi.

From Taking out Pakistan’s terror mints : The Big Story – India Today 21112016

As for the black economy, there is no doubt that the move has had, and will have, an impact. There was an awful lot of money sloshing around outside of the banking system, and as far as I understand, there was rampant tax evasion amongst the more well-off amongst the population. Having spoken to a couple of people recently returned from India, I got the impression that members of the public were comfortable that the disruption, bad though it was, was a price worth paying. And there is no doubt that the move shifted many transactions on the record immediately.

“A majority of our transactions have suddenly become white because of card payments and people are also not tipping as much now,” a waiter at the restaurant said.

From demonetisation of currency: Card payments surge, trip & steady after restricted flow of money – Times of India

The government’s plan was that people would bring their cash to the bank, declare it, pay tax on it and then either get new cash in return or actually start using bank accounts (a great many of which are dormant). And, indeed, this is what seems to have happened, with the cash being returned in amounts greatly exceeding the government’s calculations. By the end of the year, almost all of the notes had been deposited.

Banks have received 14.97 trillion rupees ($220 billion) as of Dec. 30, the deadline for handing in the old bank notes, the people said, asking not to be identified citing rules for speaking with the media. The government had initially estimated about 5 trillion rupees of the 15.4 trillion rupees rendered worthless by the sudden move on Nov. 9 to remain undeclared

From India Said to Get 97% Banned Notes in Setback to Graft Crackdown – Bloomberg

This was taken to mean that Modi had been ill-informed and that there was no corruption, and that certainly may be the case. But an alternative explanation is that people who may have been uncomfortable with depositing their money for one reason or another laundered the money before it got to the banking systems. They went out to start buying gold and jewelry for cash instead.

The gold and jewellery route has been followed by persons with black money to convert their Rs 500 and Rs 1,000 notes at a haircut of 20-40%.

From Govt likely to put curbs on jewellers | Business Standard News

That seems a reasonable deal. Pay tax to the government and potentially have to give up the rest of the cash because of anti-corruption investigations … or pay tax to the jeweler and mum’s the word. Since India has a long tradition of using gold jewelry as a store of value, this seems unsurprising in retrospect. It led to another crackdown on those who decided to convert their black money into black (but still quite liquid) gold.

This move will halt such sales of gold at a huge premium against old currency notes, which jewellers were doing till the Income Tax (I-T) department raided them across the country on Friday and sent around 600 notices to jewellers asking the details of daily sales from November 7 to 10. The I-T department, in its notices, also asked for CCTV footages, especially of cameras near cash counters, to seek date-wise information and to check if PAN numbers or ID proofs were collected from customers.

From Govt likely to put curbs on jewellers | Business Standard News

CCTV footage! Incredible.

Anyway, the upshot of all of this was that cash vanished from circulation without a viable alternative in place. What kind of alternative might there have been? Well, the answer is obvious. India really should have a widespread, vibrant and effective mobile payment infrastructure, but it has been slow to develop. I wrote about this a few years ago, noting that it was the regulatory environment that was holding back the evolution of the sector (the Reserve Bank of India’s “calibrated approach” to mobile payments). As the figures from Kenya that I recently posted show, it is possible to use mobile phones as an alternative to cash.

Look at Kenya, where there are now more than 33 million mobile money users and 174,000 mobile agent locations. The most recent figures from the Central Bank of Kenya (CBA) show an astonishing trend. From February 2013 until September 2016, the number of monthly M-PESA transactions almost tripled, going from 53 million to 131 million, while the number of card transactions fell from 34 million down to 18 million.

From Fish without cash | Consult Hyperion

So, Kenya (and, for that matter, China) show just how effective mobile solutions can be. Hence my thinking that it may have been better for India to have waited until the more flexible regulatory regime had begun bear fruit before taking the quite drastic step of removing those banknotes. I’m sure I will blog again and in more detail about the Indian experiment as more data comes in, but I think we can already see a shift in government rhetoric from corruption and terrorism to cashlessness and efficiency, with officials urging banks, merchants and mobile players to accelerate the deployment of alternatives.

Meanwhile, I just want to pull in a couple of other observations on the great experiment underway in India right now. First, the potential for alternatives:

‘Bitcoin adoption in India sees surge’

From ‘Bitcoin adoption in India sees surge’ – The Hindu

In fact, bitcoin volume on India exchanges doubled in the couple of weeks following the announcement but then fell back again at the end of the year. I think it highly unlikely that bitcoin will step in to fill the gap left by the removal of the highest value banknotes. It looks to me that a more widely-used alternative to cash will be… nothing. In the cities, the merchants are getting payment terminals or mobile phone alternatives, but outside the cities, people could easily get by for some time without a circulating means of exchange.

This is not wild prediction. I have previously posted about the famous case study of the Irish bank strikes that demonetized the Emerald Isle in the 1960s and 1970s. Subsequent economic analysis showed that the absence of money had surprisingly little impact on the economy! People just began to write cheques or IOUs and these debt instruments began to circulate.

Murphy points out that one of the key reasons why a “personalised credit system” could substitute for cash was the local nature of the circulation — which… was centred on pubs — so that the credit risk was minimised.

From Payments without banks | Consult Hyperion

In summary Ireland was a more rural economy in those days so life continued in a reputation-based transaction economy. Well, guess what: the same thing is happening in India.

However being a very close knit society, local people count on each other so they are able to buy the essential commodities from the shops in good faith, the payment of which they would make later on after having money. So this way, they are not feeling panicky like rest of the country

From Here, banks are giving only 10 rupee coins – Times of India

OK so the demonetization of Ireland and the demonetization of India are wholly different in origin, scale, purpose and destination. Still. Mr Modi’s actions must have set a few more national leaders thinking about taking radical action to move toward a less-cash economy more quickly than otherwise might have been the case – especially since we know that high-value banknotes in many countries (e.g., the UK) are primarily used for criminal purposes.

This article first appeared on Tomorrow’s Transactions

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