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Lost Due To Demonetisation

Ashok K Nag ( is Director, Center of Excellence in Analytics/Data Sciences, Narsee Monjee Institute of Management Studies, Mumbai.

Sudden demonetisation of ₹500 and ₹1,0000 notes, an elimination of existing money stock that enables economic transactions, is bound to have an economic impact, apart from penalising those who hold this money as store of their tax-evaded illegal wealth. Considering various possible scenarios, a loss of gross domestic product will be inevitable.

On 8 November 2016, Prime Minister Narendra Modi met three defence services chiefs and the national security adviser. Speculations were rife on social media that India was embarking upon another punishing move against our recalcitrant neighbour. But the bolt from the blue came from elsewhere. The Prime Minster came on national television to announce what has been called a “surgical strike” against the black economy.

The stated objective of this demonetisation of high value notes of denominations ₹500 and ₹1,000 as per the Gazette notification (Ministry of Finance 2016) are: (i) to curb the menace of fake currencies; (ii) to wipe out unaccounted and tax evaded money stored in such high-value notes; and (iii) to prevent use of high denomination notes for terror financing.

The first demonetisation happened in India in January 1946, when ₹1,000, ₹5,000, and ₹10,000 notes were taken out of circulation. These higher denomination banknotes were reintroduced in 1954, and were again demonetised in January 1978. The current demonetisation is the third in row. In 1978, the Government of India had a specific legislation called the High Denomination Bank Notes (Demonetisation) Act, 1978. This act laid down procedures for exchange of demonetised notes with notes of other denominations and allowed refusal of exchange if the authority receiving the application for exchange is not satisfied with the declarations made by a person tendering a high denomination note for exchange.

For the current demonetisation, no such specific act has been legislated and there is no provision in the notification for refusal of exchange as long as the person tendering demonetised notes can provide proof of identity. However, a severe restriction has been placed on value of notes that can be exchanged over the counter. There is no such restriction, however, if the de-notified notes are deposited in a depositor’s bank account. Obviously, such deposits would be open to scrutiny by income tax authorities and enforcement directorate to identify sources of such funds.

The underlying common theme for the two episodes of demonetisations in independent India is the respective government’s effort to curb the menace of black money. Both times, a new government had come to power riding a wave of popular anger against their predecessors who were perceived to be soft on corruption. In India there is a common perception that black money is hard cash that corrupt officials, politicians and business people hoard till they are either used for purchase of luxury goods or converted into other assets. This notion was roundly debunked by none other than the then Reserve Bank of India (RBI) Governor I G Patel. When informed about the impending demonetisation by the finance minister H M Patel, he pointed out that

such an exercise seldom produces striking results. Most people who accept illegal gratification or are otherwise the recipients of black money do not keep their ill-gotten earnings in the form of currency for long. The idea that black money or wealth is held in the form of notes tucked away in suit cases or pillow cases is naïve. And in any case, even those who are caught napping—or waiting—will have the chance to convert the notes through paid agents as some provision has to be made to convert at par notes tendered in small amounts for which explanations cannot be reasonably sought. But the gesture had to be made, and produced much work and little gain. (RBI 2005: 451)

But the main difference between 1978 demonetisation and 2016 demonetisation is the definition of what constitutes “high notes” chosen to be demonetised. A ₹1,000 note of 1978 vintage would not be less than ₹14,000 in 2016 irrespective of the deflator one uses. To put the numbers in perspective, the net per capita nominal national income in 1978–79 was ₹1,491.7. In 2015–16, the corresponding figure is ₹93,293. Thus, in 1978 the per capita income was 1.49 times of the value of the lowest denomination note that was de-notified. The corresponding figure in 2016 is 186.5. So by any account, a ₹500 note is well within the reach of an ordinary middle-class person. This means that ₹500 note would be preferred denomination for any ordinary transaction involving consumer durables. De-notification of such a medium of exchange is more likely to affect ordinary citizen’s transactional demand for cash. That is why the present demonetisation is creating such havoc across the country.

To understand the gravity of the situation let us look at how the denomination-wise distribution of our currency held by public has evolved over the past few years. The share of high value notes (notes of ₹500 and ₹1,000) in value terms has gone up from 26% in 2000–01 to 85.2% by the end of March 2016 (Figure 1). In volume terms the growth has been from 3.1% to 24.4%. To provide another perspective, let us consider M1 (narrow money) comprising demand deposits, currency in circulation and a small component called “Other Deposits with the RBI.” For all practical purposes, M1 represents transactional demand of the economy. The share of high value notes in M1 has gone up from 14.8% in 2000–01 to 54.5% by the end of March 2016. In other words, high value notes are increasingly supporting the transaction demand for money, rather than its “store of value” demand.

Economic Impact

In economics, currency used to carry out a sudden injection of money uniformly to all economic agents is known as “helicopter money.” Nobel laureate Milton Friedman first used this metaphor in his 1969 paper titled “The Optimal Quantity of Money.” If a central bank drops currency to all citizens of a country from a helicopter for their keep for ever, the result, in Friedman’s monetarist formulation of the thought experiment, would be inflation. Economists have pointed out that this experiment is nothing but a fiscal stimulation whereby the government gives a cheque to all its citizens drawn on the central bank. The immediate effect of this experiment is that the currency liability of the central bank increases with proportionate increase in loans to government on the asset side of the central bank.

Demonetisation can be thought of as opposite to “helicopter money,” to the extent that a part of the money supply gets extinguished because of the reluctance of holders of such unaccounted and tax-evaded money to exchange it for new legal tender. We may call it a “vacuum cleaning” of some part of the money supply. What would be the outcome of this experiment?

Before we look at the various possible outcomes of this experiment, it would be instructive to consider some scenarios which are neither apocryphal nor mere canards spread by opponents of this move. Let us consider a large company which routinely engages labour contractors for their infrastructure projects like highway construction. The contractor in turn engages casual labourers who are paid in cash on a daily basis. Once demonetisation process sets in, the cash flow dries up because of non-availability of required or even lower denomination notes. The project is stalled, albeit temporarily. But it results in loss of wage of labourers, reduction in profit of contractors and the process rolls up to the large conglomerate at the top. Even if there is disruption for two to three days, its monetary impact for an organisation of this magnitude would be at least a few millions of rupees.

My second example is typical of any small- to medium-sized town of India. A liquor trader with a chain of retail shops is saddled with a stash of around ₹50 million in cash. S/he is looking for Jan Dhan accounts that can be used for this purpose. Ironically, the process of vacuum cleaning unaccounted money itself is generating such money again. The trader does his business only in cash. Buying in cash from wholesaler and selling in cash to the retail customers. It is impossible for him to give credit to his customers in a trade like this. Most probably, s/he has to scale down his business drastically for next couple of months.

Loss of Business and GDP

As we have already explained, a large part of high value notes are used for transactional purpose, that is, as a medium of exchange and not as a store of value. In the cash economy, high value notes are the principal form of working capital. For the consumers, the propensity to consume leisure, hospitality and luxury goods is also very high for income in unaccounted cash. It would be possible to work out monetary value of gross domestic product (GDP) generated by use of such cash in a purely monetarist framework of money. We are using this framework as a way of illustration only. In 2015–16, the ratio of GDP at market price to M1 was around 5.2. We may reasonably assume that velocity of money in a purely cash economy would be less, as compared to that of a formal economy which is digitally connected. We can now create the following scenarios presented in Table 1.

Informal Credit Disruption

According to a study undertaken by Timberg and Aiyar (1984), informal credit markets account for as much as 20% of total credit outstanding in many Indian markets they studied. Based on their survey, they observed that creditworthiness in such informal markets are assessed based on the “cash flow” of the borrowers and not their assets. This is quite logical, as in India the prospect of any recovery by way of attachment of properties is almost nil. In a private conversation two general managers of two of the largest public sector banks confided that in their career of more than 30 years they had never recovered a single rupee from any court-ordered attachment, although they routinely obtained such attachments as a matter of office procedure.

It would not be wrong to assume that a large part of the unaccounted cash economy would not have access to formal credit market. Vacuum cleaning of cash from cash economy would deal a severe blow to the creditworthiness of the borrowers and would surely dent their economic activities. Furthermore, many borrowers would resort to repay their borrowing using de-notified cash leading to further disruption in this market. The extent of impact may be difficult to assess but it cannot be insignificant.

In such a relationship-driven credit market, cascading effect of default by any one borrower would be severe, as social, political and economic interrelationship between borrowers and lenders are much more extensive and deeper for this market.

Formal Economy Logistics

The number of pieces of high value notes currently in circulation is 22 billion. Assuming that ₹1,000 notes are replaced by ₹2,000 notes, the total number of notes that have to be reissued, works out to around 18.8 billion pieces. Replacement of such a volume of notes in 30 days would involve handling of 629 million pieces every day. If the note distribution system of RBI is unable to handle such volume of activities in such a short span of time, it would adversely affect normal business activities of many enterprises and self-employed people. It is difficult to put a number to the resulting losses but that might not be insignificant at all-India level.

Penalising Evaders

Demonetisation affects the stock of unaccounted and tax-evaded cash, but not necessarily any flow or generation process of such cash. It is possible that bureaucrats and politicians are primarily responsible for generation of unaccounted cash. But officials of the private sector are also not immune. The only difference is that the private sector, particularly large companies, generally avoid publicity and criminal prosecution of culprits. But all these people represent only the demand side of the corruption. The supply side of the corruption is represented by businesses including the corporate sector. Demonetisation affects more severely the people who operate on the demand side of corruption. This is so because the money received by them is most likely to be used either for consumption or for purchase of assets like gold, real estate, etc. These people are not entrepreneurs who would use such tax-evaded money for business purposes. As such unaccounted money in the form of cash is received over a long period, the likelihood of such people being caught with a huge stash of money at any point of time is much more than businessmen who keep unaccounted cash to meet the current demand of such cash. Even those businessmen who operate exclusively in the cash economy, particularly traders, would keep cash only as a part of working capital and not as a store of value. Thus any demonetisation is always targeted against those who hoard cash as a store of value.

Liquidity Impact on the Banks

The immediate reverse flow of cash from the purely cash economy to the formal banking sector would cause a huge surge in liquidity of regulated banking sector. The figures are staggering. The total value of high value notes outstanding as at end of March 2016 was ₹14,179.43 billion. The corresponding “total cash in hand” of scheduled commercial bank stood at ₹574.38 billion as against the total cash with the banking sector being at ₹653.68 billion. Applying this share of scheduled commercial banks to total outstanding value of high value notes, these banks are looking forward to an inward flow of ₹12,459.28 billion. The actual flow would be lesser by the amount that would get “vacuum cleaned.” Furthermore, a significant proportion would get exchanged with new notes and not remain as deposits. Even if actual flow that adds to the stock of cash in hand of the banks happens to be 50% of the outstanding amount, the liquidity of the scheduled commercial bank would increase by a factor 0f 10.8 times. A significant part of this newfound liquidity would flow to the bond market and result in increase in bond prices and concomitant reduction in yield. The resulting gain in a bank’s bond portfolio may help many banks to clean up its balance sheet which have been badly damaged due to rise in non-performing assets. Concomitantly the banks would be compelled to seek an enhanced credit off-take by reducing its lending rate.

However, the surge in liquidity will have an adverse impact also. Let us assume that this liquidity injection remains for a couple of days in the savings bank account of banks. A 4% interest for one day on one billion rupee would be around 1 lakh. Even if one trillion rupees attract interest for 5 days the interest cost to the banks would be ₹500 million. If the market takes time to return to its normal state, this cost would increase significantly.

Government Tax Receipts

Even if 10% of new cash flow to the regulated sector attracts penal provisions of taxation, the government coffer would be richer by at least ₹10 to ₹20 billion. We may recall that around ₹650 billion were declared by the recent voluntary disclosure scheme. A little above ₹29 billion was received by the central government by way of penal tax. Out of ₹1.5 trillion deposited so far, if the government can levy tax to the tune of 100% on even 10% of this amount of money, it would be richer by another ₹150 billion as against the expected receipt of ₹3.5 trillion.

RBI’s Balance Sheet

Currency notes with public is a liability for the RBI. Once a part of outstanding high value notes get “vacuum cleaned” they cease to be a liability to RBI. According to the latest balance sheet, its total liabilities stood at ₹32.4 trillion. The liabilities on account of issuance of currency stood at 52.65% of the total liability. As we have already noted, around 85% of currency liabilities would be on account of high value notes which now stand de-notified. A 10% “vacuum cleaning” would amount to reduction of RBI currency liabilities to the tune of ₹1.4 trillion. If the RBI writes it back and treats as its income, RBI would reap benefits. Let it be noted that RBI transferred only ₹658 billion of rupees to the Government of India last year while the budget deficit for the financial year 2015–16 was around ₹5.32 trillion. As the budgeted fiscal deficit for 2016–17 remains same in absolute amount, this could mean the deficit would come down at least by one percentage point. Thus if the central government does not use the extra transfer from the RBI for additional capital expenditure and thereby offset the contracting effect of “vacuum cleaning” of high value notes, the country on balance is a net loser on account of this move of the central government.

Only a Minor Bump

Finally, the most important point that needs an answer from the policymakers is whether this demonetisation initiative would be followed with policy measures that would stop or at least curb the generation of black money. Elimination of current stock of unaccounted and taxevaded money does not imply that generation of such money is being stopped. It would only mean that a new set of players would replace the older ones, but the game would continue. To give one example, the RBI has repeatedly warned against misuse of Participatory Notes in capital market transactions. Nothing has been done so far. In many countries government spending at transactional level has been released under Open Data licence. This has been a very effective anti-corruption move. Many similar measures can be suggested which will strike at the root of corruption. Demonetisation can at best be a temporary road bump but it would not stop the onward journey of the chariot of corruption.


Ministry of Finance (2016): “The Gazette Notification No 2652, November 8,” New Delhi, Controller of Publications.

RBI (2005): History of the Reserve Bank of India (1967-81), Vol III, viewed on 17 November 2016,

Timberg, Thomas A and C V Aiyar (1984): “Informal Credit Markets in India,” Economic Development and Cultural Change, Vol 33, No 1, pp 43–59.


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