November 8, 2021 marks five years of demonetisation in India. On this day in 2016, in a televised address at 8 pm, Prime Minister Narendra Modi declared that currency notes of ₹ 500 and ₹ 1000 -- these two denominations were 86% of the currency in circulation at the time in terms of value -- would cease to be legal tender. What has changed in the Indian economy in these five years? How many of these changes are linked to demonetisation?
The surgical strike on illegal cash that wasn’t
While demonetisation was subsequently described as a policy boost to promoting digital payments, the original policy had very different stated targets. The biggest promise of demonetisation was that it would purge unaccounted cash in the system, with those hoarding forced to deposit it in the banks.
The Prime Minister’s speech announcing the policy said: “Which honest citizen would not be pained by reports of crores worth of currency notes stashed under the beds of government officers? Or by reports of cash found in gunny bags”. The implicit idea was that those who had unaccounted cash with them would be forced to either declare it to the tax authorities or just get rid of it. Many described demonetisation as a sort of surgical strike against corruption.
This idea was also supported by some economists, such as Soumya Kanti Ghosh, the chief economic advisor of India’s largest bank, the State Bank of India. In an article published in the Business Standard newspaper on November 14, 2016 Ghosh estimated that “roughly around ₹ 4.5 lakh crore of (demonetised) money could disappear from the system”. “On the lighter side, we hope too big an amount of such notes are not burnt adding to the Delhi smog”, Ghosh added in that article.
Such hopes (and potential fires) were extinguished very soon. In his budget speech after demonetisation on February 2, 2017, then finance minister Arun Jaitley gave the first hints that demonetisation had not led to large scale purge of unaccounted cash deposits. “After the demonetisation, the preliminary analysis of data received in respect of deposits made by people in old currency presents a revealing picture. During the period 8th November to 30th December 2016, deposits between Rs2 lakh and Rs80 lakh were made in about 1.09 crore accounts with an average deposit size of Rs5.03 lakh. Deposits of more than 80 lakh were made in 1.48 lakh accounts with average deposit size of Rs3.31 crores”, the Budget speech said.
This author had put these numbers into context in a Mint article published on February 2, 2017. “The total amount which has been deposited under these two categories can be calculated by multiplying the number of accounts with the average deposit figures mentioned by Jaitley. This gives a figure of Rs5.48 lakh crores for deposits worth less than Rs80 lakh and Rs4.89 lakh crore for more than Rs80 lakh. The aggregate deposits under the two categories amount to Rs10.38 lakh crore. This works out to around two-third of the total value of demonetised currency, which was valued at around 15.44 lakh crore. These figures also tell us that around 31% of the total value of demonetised currency has come back in individual deposits of Rs80 lakh or more. These figures show that a large chunk of the demonetised currency which has come back into banks is from the super-rich”, that article said.
By the time the Reserve Bank of India came up with final figures about the amount of demonetised currency returned to banks, the figure was more than 99%.
Has demonetisation pushed India towards a cashless trajectory?
Describing demonetisation as a nudge towards digital payments, which is how the policy is justified by many people today, was an after-thought although the original policy announcement did talk about reducing the amount of cash in circulation in the Indian economy.
“The magnitude of cash in circulation is directly linked to the level of corruption. Inflation becomes worse through the deployment of cash earned in corrupt ways. The poor have to bear the brunt of this. It has a direct effect on the purchasing power of the poor and the middle class. You may yourself have experienced when buying land or a house, that apart from the amount paid by cheque, a large amount is demanded in cash. This creates problems for an honest person in buying property. The misuse of cash has led to artificial increase in the cost of goods and services like houses, land, higher education, health care and so on”, the Prime Minister’s speech of November 8, 2016 said.
While digital payments have increased significantly since demonetisation (more on this later), whether or not India has become a cashless economy post demonetisation is a different question. The best metric to answer this question is to look at the ratio of currency in circulation (at the end of a fiscal year) and the nominal GDP (in that fiscal year). Currency in circulation was 12.1% of India’s nominal GDP in 2015-16, the year before demonetisation. It plummeted to 8.7% in 2016-17 as the banking system was struggling to put cash back into the system after demonetisation. Since then, this ratio has climbed steadily and it reached 12% in 2019-20. A restoration of currency in circulation to nominal GDP ratio shows that there was no significant impact of demonetisation until 2019-20.
This number reached an all-time high of 14.5% in 2020-21. The latest number is more a result of the pandemic’s economic disruption; 2020-21 saw an annual contraction of 3% in India’s nominal GDP, which pushed up the cash-GDP ratio, than a sudden increase in preference of cash in the Indian economy.
Did demonetisation lead to a tax-windfall for the state?
This is a more difficult question to answer than the cashless economy question. The reason is, demonetisation was not the only policy change which has affected tax collections in India. It was followed by the roll-out of Goods and Services Tax in July 2017. In September 2019, the government announced a significant reduction in Corporation Tax rates, which led to a sharp fall in direct tax collections. Even as economic observers were waiting for the long-term effects of corporation tax cuts, the economy was hit by the pandemic, which led to a sharp fall in GDP and hence tax collections across the board. With these caveats in place, a look at the central government’s gross tax collection vis-a-vis its budgeted targets — they are the best measure of whether the government’s own expectations about tax collection have been fulfilled — does not show much of an improvement after demonetisation.
An even bigger question about the long-term gains of demonetisation for the economy comes from the fact that GDP growth rate started declining sharply in the post-demonetisation years. India’s GDP growth rate increased consistently from 5.2% in 2011-12 to 8.3% in 2016-17. This trend reserved itself and the economy started losing growth momentum with the GDP growth reaching just 4% in 2019-20. With the pandemic year witnessing the highest ever GDP contraction of 7.3% in 2020-21 and a strong base effect in GDP numbers for 2021-22 and perhaps even 2022-23, the waters are now far too muddied to make any scientific assessment about demonetisation’s impact.
Demonetisation’s impact on digital payments and formalisation of the economy
Two recent developments have rekindled the debate on the long-term gains of demonetisation. The value of transactions through the Unified Payments Interface (UPI) crossed $100 billion in October 2021. UPIs were only introduced in the post demonetisation period in the country and their rapid growth is truly stellar. This is an innovation of global scale and quality.
A research note issued by Soumya Kanti Ghosh on November 1 said that the Indian economy had undergone a large-scale formalisation in the post-demonetisation years. The note cites a National Statistical Commission estimate of informal sector share of 52% in 2017-18 and claims that this has come down to at most 20% of the country’s GDP.
The note lauds this development. “Formalisation of an economy is always better from a policy perspective”, it says. To be sure, the note also calls for providing relief to the poorer sections of the society. “Hence it is important and ethical that even as we formalise, we must support honest tax paying households, through a better designed tax structure, particularly indirect taxes on items like fuel”, it said.
Is a surge in digital payment channels such as UPI and supposedly rapid formalisation of the economy the beginning of realisation of the long-term benefits of the government’s pro-formalisation approach; demonetisation, being the first of these? The answer is more nuanced than what some people might want us to believe.
Let us look at the rapid growth of UPIs first. This would not have been possible without the widespread expansion in mobile internet and smartphones in the country, which has allowed consumers and businesses to conduct even small ticket digital transactions without the infrastructure of point of sale (POS) machines. It is also a fact that some of the transactions happening through UPI used to happen through credit or debit cards previously. The value of transactions via credit and debit cards today is significantly lower than it was a couple of years ago. While UPI transactions have grown at the cost of other forms of digital transactions, overall too, there has been a sharp growth in them. The digital transactions space today is far more robust than it was five years ago. Even small-ticket transactions are now carried out digitally, and are far more commonplace than in the period before demonetisation.
Let us take the question of policy-driven formalisation now. There is some merit in Ghosh’s argument that a more formal economy is better even from a pro-poor perspective. For example, the current government has brought millions of people under the formal banking sector by opening Jan Dhan Accounts. This infrastructure allowed it to make cash transfers (even if there have been quibbles about the amounts) to such families during the nation-wide lockdown last year. Similarly, the ongoing efforts to build a database of migrant workers will give a better handle for future policy intervention.
While these developments are definitely laudable, they are far from sufficient to meet the central challenge of generating quality employment for millions of Indian workers. In some cases, formalisation of the economy can perpetuate, even worsen working conditions in the short-term. Anecdotally, the Goods and Services Tax, introduced in 2017, has also been responsible for formalizing the economy — by forcing more businesses to come into the tax net. But in the process, it has made some small businesses uncompetitive.
A research note dated July 15, 2021 by Pranjul Bhandari, chief India economist at HSBC Securities and Capital Markets Research has a useful perspective on the issue of policy-driven formalisation.
“But “formalisation” can be a double-edged sword. If it happens at the cost of putting small informal firms out of business, then the disruption in the informal sector can weigh on demand in subsequent periods. It is also possible that formalisation wears off over time. If the ecosystem that promotes formality does not change very much, the informal sector makes a comeback. And in that case, the efficiency gains associated with formalisation wears off. The constructive way to think about this is perhaps to differentiate between ‘forced’ and ‘organic’ formalisation. The formalisation that comes only on the back of external pressure or leads to deep distress in the informal sector, may not be sustainable. In contrast, the formalisation that happens on the back of policy changes which help small and informal firms grow over time into medium or larger formal sector firms, is more sustainable.”
Vineet Sachdev contributed to this story
