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Published on: May 21, 2024
#Financial Markets
Demonetisation is the national currency change that removes a currency unit from its legal tender. How did this impact the Indian economy when they made such a decision in 2016?
On 8th of November 2016, the government of India, under the leadership of Prime Minister Narendra Modi, announced the demonetisation of the banknotes of Rs. 500 and Rs. 1,000. Mr. Modi also announced the issuance of the new banknotes of Rs. 500 and Rs. 2,000 in exchange for the demonetised banknotes. The government said they undertook demonisation aiming to curtail black money, spur a cashless, digital economy, and reduce the use of illicit cash for illegal activity and tax evasion.
“To break the grip of corruption and black money, we have decided that the five hundred rupee and thousand-rupee currency notes presently in use will no longer be legal tender from midnight tonight, that is, 8th November 2016,” Mr Narendra Modi said.
This became the largest example of global demonetisation by invalidating 86% of the currencies overnight. Below, we will discuss what demonetisation is, how it works, and the economic impact it had in the Indian economy.
Demonetisation is the national currency change that removes a currency unit from its legal tender. The U.S. was the first to introduce demonetisation with the Coinage Act of 1873. The US government made silver legal tender instead of gold as part of this move. The exercise led to a severe economic depression for the next few years, which compelled the US government to introduce the Bland-Allison Act of 1878 to reinstate silver.
In India, 2016 was not the first time the country undertook the demonetisation exercise. In 1978, the Indian government introduced the High Denomination Bank Notes (Demonetisation) Act 1978, which demonetised the high-denomination banknotes of Rs. 1,000, Rs. 5,000, and Rs. 10,000.
India demonetised the Rs. 500 and Rs. 1,000 banknotes on 8 November 2016. The Reserve Bank of India (RBI) began preparing for new banknotes of Rs. 2,000 in May 2016. The RBI was apprised of the demonetisation from the Ministry of Finance, arguing that the supply of Rs. 500 and Rs. 1,000 banknotes outgrew the country’s economy growth rate during 2011-2016.
However, the RBI board disagreed with the claims, saying that the government compared GDP growth in real terms with the growth of currency supply in nominal terms. Nominal GDP growth had summed to over 80% during 2011-16 and hence was in line with the development of the currency bills to be demonetised. According to them, most people don’t hold undeclared cash assets.
PM Modi nevertheless went ahead with the decision. People could exchange their banknotes for fifty days until 30 December 2016. Initially, individuals could withdraw a maximum of Rs. 10,000 per day and Rs. 20,000 per week before the limit was increased to Rs. 50,000 per week. By March 2017, the RBI removed all the restrictions.
As part of the demonetisation, a total of 15.4 trillion banknotes of Rs. 500 and Rs. 1,000 were withdrawn, accounting for approximately 86.5% of the currency under circulation. The RBI later indicated in a report that 99.3% of the demonetised currency, or roughly Rs. 15.31 trillion, was returned.
Within three months of the decision, the RBI published a report on the macroeconomic impact of demonetisation. The central bank claimed that the move’s adverse impact was transient during November-December 2016, and the situation started to get better only by mid-February of the following year. Below, we will share a few stats on the effects of demonetisation on different aspects of the Indian economy, including business, tax rates, digital transactions, and more.
Demonetisation adversely affected the mico, small-and medium-sized enterprises (MSME) sector, the backbone of the Indian economy, where wages are paid mainly in cash. However, the corporate industry appeared to have remained largely resilient to the impact of demonetisation.
In agriculture and plantation activity, sowing, which was higher by 4.8% in November 2016 than a year ago, picked up subsequently and was about 6% higher by February 2017. The healthy produce during those months successfully mutated the potentially adverse impact of demonetisation.
○ The sale of fast-moving consumer goods (FMCG) and automobiles declined from November 2016 to January 2017.
○ Contraction in the Purchasing Managers' Index (PMI) in December for the first time in 2016.
○ PMI services fell sharply from 54.5 in October 2016 to 46.7, contracting for the first time since June 2015.
○ Cement production, one of the leading indicators for the construction sector, contracted by 8.7% in December 2016 and 13.3% in January 2017.
○ 1.5 million jobs were lost in the immediate aftermath of demonetisation, as reported by the Centre for Monitoring the Indian Economy (CMIE).
○ The Indian economy recovered from the global financial crisis in 2008, with the gross domestic product (GDP) increasing by 8% in Q4 of 2015-16. After demonetisation, the GDP growth rate came down to 5.7% in Q2 of 2017-18.
Image: GDP growth % per quarter, 2013-2017, India
One of the main goals of demonetisation was to curb black and corrupt money. However, it was merely a backwind since it couldn’t impact the creation of black money in the future or stop converting it into different forms, such as property, gold, etc. Before demonetisation, the currency under circulation was Rs. 18.4 lakh crore, or about 12% of the GDP. Out of this currency, about Rs. 15.44 lakh crore constituted Rs. 500 and Rs. 1,000 notes which were invalidated.
It left only about Rs. 3 lakh crores, which shocked businesses and affected normal business transactions. The economy was, therefore, remonetised with new Rs. 200, Rs. 500 and Rs. 2,000 banknotes. However, even after demonetisation, the total amount of currency in circulation was Rs. 15.32 lakh crore (about 9% of GDP).
Although the Indian government meant to protect its economy from black and corrupt money, the demonetisation of employment cost the country over Rs. 1.27 trillion and 1.5 million jobs. The Indian government spent Rs. 170 billion printing new currency, transportation, security, logistics, and other related expenditures.
Despite demonetisation positively impacting the tax base by bringing in 9.1 million new taxpayers in 2016-17 and 12.8 million in 2017-18, most Indian economists didn’t stand by the decision. Amartya Sen, a Nobel laureate, described the exercise as [it]
"undermines notes, it undermines bank accounts, it undermines the entire economy of trust."
This article is for informational purposes only and not intended as investment or financial advice. It contains opinions and speculations that are subject to change without notice.
The author and publisher disclaim any liability for decisions made based on the content of this article. Readers are advised to conduct their own research and consult a financial advisor before making investment decisions.
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