Show me the money: demonetisation and trust

Sunit Arora examines what the latest round of demonetisation in India means for digital payments and trust in the currency.

“We don’t accept the ₹2,000 note”. Printouts with these words have been spotted near checkout counters in a few restaurants, shops and establishments in smaller cities and towns in India after the Reserve Bank of India (RBI) announced last month that its highest-denomination currency note (worth about £19) is being withdrawn from circulation in a phased manner up to September 30, 2023.

Other establishments have chosen to subtly cite the absence of small change to turn away customers who proffer the pink-coloured notes sporting Mahatma Gandhi’s image. Larger, established businesses don’t have that luxury. Petrol pumps, for instance, have seen an increase in customers paying with the ₹2,000 note. Noteholders have also headed to India’s extensive bank network to exchange or deposit them despite the scorching summer weather.

Demonetisation 2.000

News of the withdrawal of a currency note can be expected to trigger some apprehension and fear in India. Memories of the shock demonetisation in November 2016, when 86% of the currency in circulation by value was withdrawn overnight leading to a major disruption in people’s lives, are still fresh. That is why there has been considerable scrutiny in the public domain of the central bank’s motivations and the timing of this currency withdrawal.

Aware of the potential for panic, the RBI has played it carefully. Holders of these notes have been given a four-month period to exchange them for other currency or deposit them into bank accounts, subject to a one-time transaction limit.

The central bank emphasized that the notes (which account for ₹3.62trnor 10.8% of currency in circulation by value as of March 31, 2023) would remain legal tender. However, the RBI is tight-lipped about what happens after September 30, the deadline up to which people are “encouraged to” deposit or exchange the notes.

Despite the lack of clarity on ‘why’, the process appears to be going smoothly. The RBI said on July 3 that 76% of the ₹2,000 notes have been returned. It added that 87% of these were deposited into bank accounts. According to central bank data for the fortnight ended June 2, almost 40% of the returned currency was back in circulation in the form of smaller notes. The withdrawal of notes is expected to temporarily lead to increased surplus liquidity in the banking system.

Unanswered questions

Even so, it’s a mystery why the RBI chose to withdraw these notes in such a manner, when it could have allowed them to slowly disappear from circulation. The ₹2,000 were introduced soon after the 2016 demonetisation in order to quickly get cash into the system (on March 31, 2018, they were 37.3% of notes in circulation by value).

The central bank did not print these notes after 2018-19 and slowly they had started slipping out of everyday circulation. It is quite evident Indians prefer to transact with notes of smaller denomination. The central bank cited its “clean note policy” – where it regularly withdraws soiled notes – as one of the reasons for the withdrawal.

However, when asked about why there was a need for a deadline for returning the notes, the RBI governor said it was to impart “finality” to the process.

Black money

There were three reasons initially served up by the government for demonetisation in 2016. First, to break the back of “black money”, or income on which taxes have not been paid. Second, to end the circulation of fake currency and, third, to end terrorist financing.

The main objective – to weed out black money – failed: most of the demonetised notes (99.2%, to be precise) made their way back into the system during the government’s stipulated 50-day period to exchange them in banks. The government expected a quarter to a third of the demonetised notes not to return into the banking system. However, tax evaders found innovative ways to launder their money. While some fake currency was turned in, counterfeit currency in the new notes continues to be reported.

India remains a predominantly cash economy. The currency-in-circulation-to-GDP ratio was 12.7% as of March 2023. This number has indeed fallen when compared to the previous two years (13.4% in March 2022 and 14.4% in March 2021), but these were pandemic years, when people stocked up on cash. In fact, Vivek Kaul writes in Deccan Herald that the CIC ratio in India over the 10 years preceding demonetisation averaged 12.1%.

There is a misplaced perception that a cash-fuelled economy fuels tax evasion. Sure, cash makes it easier to avoid tax audits for some. But there are cultural factors driven by convenience and trust that have led many Indians to prefer transacting in cash. Cash is the most direct form of payment, with no intermediaries. High currency-in-circulation-to-GDP ratios can also be seen in countries like Japan, Hong Kong, the Euro area, and Switzerland (these can hardly be called backward economies with high tax evasion rates).

The digital push

Of course, led by the unified payments interface (UPI), digital payments have been growing fast in India and there has indeed been some change in mindset in urban and semi-urban areas. This has led the government to post facto link the digitalisation and formalisation of the Indian economy as one of the consequences of demonetisation.

In recent years, India has rapidly become the third largest fintech ecosystem by user base after the US and China. Apart from ease of use, demonetisation has played a role in that, as has the pandemic. This begs a question: could the withdrawal of the ₹2,000 note be part of a plan to nudge consumers to digital payments over the longer term?

If so, there may be better ways of going about it. Most observers agree India’s demonetisation was faulty policy making. It was a “massive, draconian, monetary shock” to the system, the then chief economic advisor Arvind Subramaniam wrote in a book called Of Counsel published in 2018.

Apart from slowing down the economy for a couple of years after the event, it dented the public’s trust in the money they hold. And, as any banker will affirm, trust is the cornerstone of a currency.

Sunit Arora is an independent journalist and editor based in Delhi. His twitter handle is @sunitarora

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