Demonetisation

Demonetisation refers to the act of stripping a currency unit of its status as legal tender, meaning the currency cannot be used to pay for goods and services. Read here to learn more.

On November 8, 2016, the government of India announced a sudden and unexpected demonetisation of two of its highest denomination notes at the time, the ₹500 and ₹1,000 banknotes, which constituted over 86% of the currency in circulation.

This move was directed by Prime Minister Narendra Modi, with the primary goals stated as curbing corruption, black money, counterfeit currency, and terror financing.

What is demonetisation?

Demonetisation is a governmental policy whereby a form of currency is stripped of its legal tender status.

In essence, demonetisation involves withdrawing a particular denomination or form of currency from circulation, thereby prohibiting its use in conducting transactions.

The demonetized currency is either replaced with new notes or coins of the same or different denomination or is completely phased out.

The French were the first to use the term “demonetise” in the years between the years 1850-1855.

Objectives of Demonetisation

• Curbing Black Money: Targeting the hidden wealth that is not declared to the tax authorities, which often lies in high denomination notes.
• Fighting Corruption: By making large hoards of cash obsolete overnight, the move aimed to crack down on corruption and illegal cash holdings.
• Counteracting Counterfeit Currency: To eliminate counterfeit notes used for terror financing and other illegal activities.
• Promoting Digital Payments: Accelerating India’s transition to a digital economy, encouraging the use of electronic payments over cash transactions.
• To Combat Inflation: By pulling out a portion of the currency in circulation, demonetisation can help in controlling inflation to some extent. However, this depends on how the economy reacts to such a move.
• To Target Illegal Activities: Since illicit activities like drug trafficking, terrorism financing, and money laundering often rely heavily on cash, demonetisation can disrupt these operations by making the cash they hold obsolete.

Implementation and Immediate Effects

The process of demonetisation typically requires a sudden announcement to prevent hoarders of illegal wealth from disposing of their cash reserves.

However, this can lead to short-term disruptions in the economy, affecting businesses and individuals who rely heavily on cash transactions, especially in regions with limited banking infrastructure.

• The announcement was made unexpectedly in the evening, and from midnight of the same day, the specified notes were no longer legal tender. People were given a window period to deposit the old notes in their bank accounts or exchange them for new ₹500 and ₹2,000 notes introduced by the Reserve Bank of India (RBI).
• The immediate aftermath saw widespread chaos, long queues at banks and ATMs, and a significant cash crunch that lasted for several months.

This period of adjustment had a profound impact on the daily lives of people, particularly those in rural areas, the informal sector, and small businesses that predominantly relied on cash transactions.

Outcomes and Criticism

• Economic Impact: The demonetisation drive had a mixed impact on the Indian economy. In the short term, it led to a slowdown in economic growth due to the cash crunch. Small businesses and the informal sector were hit hard, and job losses were reported across various sectors. However, it also led to a significant increase in digital transactions, fostering a shift towards a more digital economy.
• Reduction in Cash Use: While there was a temporary reduction in cash use and a spike in digital transactions, cash usage eventually returned to pre-demonetisation levels, albeit with a sustained increase in digital transactions.
• Black Money and Tax Collection: The effectiveness of demonetisation in curbing black money has been a subject of debate. A significant portion of the demonetised currency was returned to the banking system, leading to questions about the amount of black money addressed. However, there was an increase in tax compliance and the number of tax returns filed, suggesting a broader base for taxation post-demonetisation.

Critics argue that the goals of demonetisation were not fully achieved and that the move caused unnecessary hardship to the poorest and most vulnerable sections of society. The suddenness of the policy and its execution was also criticized for the economic disruption it caused.

Demonetisation in India

2023: The Supreme Court in a majority 4-1 verdict with four judges on a five-judge Constitution Bench held that- the November 8, 2016, notification withdrawing the legal tender of these notes “does not suffer from any flaws in the decision-making process”.

• The centre’s decision six years ago to demonetise currency notes of Rs 500 and Rs 1,000 was upheld through the verdict.

RBI Act section 26

The RBI Act has been enacted to regulate the issue of bank notes and generally to operate the currency and credit system of the country.

• Section 26(1) of the Act provides that every bank note shall be a legal tender as per the amount expressed therein and shall be guaranteed by the central government.
• As per Section 26(2) of the Act, bank notes can cease to be legal tender when the central government issues a notification in the Gazette of India declaring that with effect from such date as may be specified in the said notification any series of bank notes of any denomination shall cease to be legal tender. Such a notification may be issued on the recommendation of the Central Board of the Bank.

History of demonetisation in India

1946

The first demonetisation in British India was carried out on January 12, 1946. An Ordinance demonetised currency notes of Rs 500, Rs 1,000, and Rs 10,000 which were in circulation, primarily to check the unaccounted hoarding of money, with a directive that they could be exchanged for re­issued bank notes, within ten days.

1978

The second demonetisation was carried out in the year 1978, in pursuance of the recommendation of the Wanchoo Committee appointed by the central government. The government resorted to demonetisation of bank notes of denominations Rs 1,000, Rs 5,000, and Rs 10,000 notes on January 16, 1978, under the High Denomination Bank Notes (Demonetisation) Ordinance, 1978, and people were allowed three days to exchange their notes.

Which countries have demonetised in the past?

The global history of demonetisation is varied, with numerous countries resorting to this measure under different circumstances.

USA (1873)

One of the earliest instances of demonetization was in the United States. The Coinage Act of 1873 mandated the removal of silver in favor of adopting the gold standard as the legal tender. This led to a contraction of the money supply and a 5-year economic depression in the country. The dire situation and pressure from silver miners and farmers forced the implementation of the Bland-Allison Act in 1878 which re-monetized silver as legal tender.

1969

President Richard Nixon declared all bills above $100 null and void in the United States of America to curb the existence of black money. The move was highly successful and is claimed to have been the start of the development of the American banking system.

Great Britain (1971)

Before the year 1971, the currency of the pound and penny used to be in circulation in Britain but to bring uniformity in currency, the government stopped the circulation of old currency in 1971 and introduced coins of 5 and 10 pounds.

Ghana (1982)

Ghana experienced demonetisation under the rule of Jerry Rawlings, to combat tax evasion and corruption. The policy targeted wealthy individuals who had evaded taxes or acquired their wealth through corruption means, requiring them to exchange their old currency for new notes within a limited period.

Nigeria (1984)

Nigeria’s government, under then-military ruler Muhammadu Buhari, announced a currency change in 1984 to tackle corruption and reduce the amount of money outside the banking system. It was a bid to control inflation and promote economic stability, though it also led to immediate economic hardships for the population.

Soviet Union (1991)

Shortly before its collapse, the Soviet Union attempted demonetisation by withdrawing large-denomination ruble notes from circulation. The goal was to combat the black market and reduce money laundering activities. However, the move was met with widespread panic and confusion, contributing to the economic turmoil of the period.

European Union (2002)

The introduction of the Euro in 2002 as a physical currency across 12 EU countries (at the time) involved a massive demonetisation exercise of national currencies like the Deutsche Mark, French Franc, and Italian Lira. While this was not demonetisation in the traditional sense of combating black money, it was a unique instance of replacing multiple national currencies with a single one, aiming to facilitate trade, ensure stable prices, and establish a more integrated European economy.

Zimbabwe (2015)

Zimbabwe underwent a demonetisation process in 2015 to phase out the Zimbabwean dollar, which had become worthless due to hyperinflation. The country had already been using foreign currencies like the US dollar and South African rand for transactions. The move was part of an attempt to stabilize the economy and restore confidence in the financial system.

Also read: Rs.500, Rs.1000 Currency Notes Scrapped: What you need to know

Conclusion

Demonetisation was one of the most significant and controversial economic policies implemented in India’s recent history.

Its long-term effects, particularly on black money, digital payments, and the broader economy, continue to be debated. While it achieved some of its objectives, such as an increase in digital transactions and greater tax compliance, the move also highlighted the challenges of implementing radical economic policies without comprehensive planning and gradual implementation.

The lessons from India’s demonetisation experience offer valuable insights into the complexities of tackling corruption and black money within a large and diverse economy.

-Article by Swathi Satish