What happens when the cash disappears?

ULSB PhD student Secki Jose explores the paradoxical effects of India’s recent decision to get rid of some of its banknotes to combat corruption. Secki can be emailed on spj15@le.ac.uk.
 
At the stroke of midnight on November 8, 2016, India launched what seemed like an extraordinary experiment in monetary economics. Identifying India’s historical problems of corruption and national security as being caused by easy cash, a war was declared – on cash money. India attempted a ‘demonetisation’ by scrapping the existing denominations of 500 and 1000 Rupees that formed around 86 percent of the paper notes in circulation. Any cash over a specified limit that you brought into the bank after this date would be heavily taxed and your finances subject to the taxman’s scrutiny.

It seemed like a bold move, and one that seemingly had the ability to strike at all the evils in the country. But did it have any effect? I was fortunate to be in India starting from the second week of this ‘demonetisation’ and was able to closely follow its trajectory and the corresponding events on the ground.
 

A curious thing had been happening in India over the previous three years. The rate of cash in the hands of the public had been rising much faster than the rate of growth of the broad money supply. In other words, the people were accumulating cash outside the banking system faster than it was being printed out by the central bank. No one could explain the reason for this rise in cash holdings despite there being several developments that appeared to run in the opposite direction (such as e-banking and mobile banking).

Several suggestions were put forward to explain this but all involved a high degree of speculation because the money, by definition, was outside the banking system. It is also disconcerting for a central bank like the Reserve Bank of India (RBI). The more the cash floating outside the formal banking system, the less control the RBI and the government has over the size of transactions as well as monetary policy in general.
 

Demonetisations have been done for a variety of reasons in the past. Its most common form is seen in ‘redenomination’ where inflationary, high face-value notes are removed from circulation. Other examples include the removal of very low values that are no longer used, or removal due to adoption of new systems – such as the British ‘decimalisation’ in 1971-72, or the introduction of the Euro. But this was probably the first time that a country tried demonetisation to tackle corruption. That the unabashedly right-wing Indian PM could also sell it as being an anti-terrorist move, as well as a nationalist one, was an added bonus.

For anyone who has studied monetary history and its vagaries, Demonetisation is a nerve-wracking experiment. It is therefore no wonder that there were almost no established academics or economists behind this idea. The previous Governor of the RBI, Raghuram Rajan – an economist of some standing – had resigned and left 2 months before the demonetisation. Economists have been split on the consequences of the move with the two camps being bitterly divided. One side argues that the move has been successful in unearthing money that had been hidden away, whilst the other side points to the damage to the economy and the poor in particular. Both the positions in the argument have their merits, but I’m not going to explore those here. Instead, I want to point out that there were two striking things about these discussions.

 
First was the lack of any solid data to back up any arguments. The large size of India’s informal sector, both in terms of employment and cash transactions, means that there are few ways to capture any real-time changes happening in the economy. The formal sectors with good data were already integrated into the digital economy and banking system and so faced less disruption. It was the cash intensive informal economy that has really faced the brunt of the demonetisation. And there is little anyone can do to measure it. This meant that there were only a few small stories that could be used as evidence, but no way of gauging the move’s wider impact.

 
The second major issue was about how to interpret the results. Since something of this scale or nature was unprecedented, there was confusion on what was the meaning of the information coming in. For example, it seems that almost all the targeted cash has come back. But does that mean that there was no ‘black’ money left or does it mean that those with ‘black’ money managed to slip it back into the banking system? Failure to release statistics by the RBI has only exacerbated this confusion.

The subsequent actions of the Indian government have shown that it is looking to continue to combat cash holdings, as it sees cash as the oil that fuels corruption. However, not only has this resulted in new ‘innovative’ forms of evasion but crucially, there is no way of ensuring that the ruling dispensation itself remains corruption-free. There is a consensus that the overall execution was shambolic with dead cash machines, long queues, incompatible currency sizes and daily flip-flops by the RBI. But the overall effect of demonetisation was simply obscured by India’s large informal sector – where there are few clear measurables.

With all sides trading barbs, the elections in the coming years will tell us whether ordinary people think that the whole exercise was a success or not. The people in the informal sector whom I spoke to seemed to think of it as just another part of the general turbulence of their lives. They hope that all the trouble helped the country in some of the ways that they had been told it would. I’m not sure whether we will or can ever know whether that was the case.