One year ago, in an unscheduled live televised address, India’s Prime Minister Narendra Modi announced that within weeks the ₹500 and ₹1000 banknotes would become worthless. Prime Minister Modi framed this so-called “demonetization” policy as part of the battle against corruption and illicitly-obtained “black money,” which had “spread their tentacles” through the India economy. The Prime Minister identified two ways that demonetization would combat corruption. First, the surprise devaluing of currency would leave criminals, including corrupt officials, with millions of rupees’ worth of currency that would suddenly become worthless, and those holding large stashes of black money would be unwilling or unable to exchange it without having to explain where the money came from. Second, going forward, demonetization would make it more difficult to hold, transport, or exchange large quantities of cash (particularly since the Indian government was demonetizing the two largest notes in circulation); as the Prime Minister emphasized, “[t]he magnitude of cash in circulation is directly linked to the level of corruption.”
One year out, it is increasingly clear that India’s demonetization experiment imposed tremendous social and economic costs but failed to achieve either of these objectives (see here, here, and here). A closer examination of the reasons for this failure may help us understand both the potential and limits of demonetization as a tool to combat corruption and the underground economy.
Consider first the Indian government’s hope that surprise, rapid demonetization would flush black and counterfeit money out of the system, leaving corrupt officials and other criminals stuck with piles of worthless illicitly-obtained cash. This clearly failed: The Reserve Bank of India recently reported that almost 99% of the demonetized currency was returned to the banks, vastly exceeding the amount the Indian government expected would be returned. Moreover, less than 0.0007% of the cash returned was counterfeit, also eliminating the prospect that demonetization would expose large sums of counterfeit currency. There are three main reasons that India’s demonetization failed in its objective of flushing existing stocks of illicit money out of the system:
- First, the Indian government overestimated the black economy’s reliance on the large demonetized bills. In fact, less than 10% of India’s black money is stored in cash, with much more stored in property and gold.
- Second, the government underestimated the ability of black economy operators to exchange black money for white money and to take money out of India’s robust informal economy, thus effectively sanitizing their money without having to deal with the government. Within days of Prime Minister Modi’s announcement, the phrase “How to Convert Black Money to White Money” was a top search on Google in India. Those holding large piles of cash that they didn’t want to report found a variety of ways to dispose of this cash without having to deposit it in banks, for example by giving loans to poor people, buying gold and property, and making use of organizations like the “banknote mafia.”
- Third, and perhaps most importantly, the government underestimated the ability of black market operators to devise complex money laundering schemes to formally deposit their black money into banks through money mules, certain basic banking accounts, and cooperative banks.
Next consider the second way in which demonetization was supposed to suppress corruption and other illegal transactions, by making it more difficult to hold, transport, or exchange large amounts of cash. Here the government seems—ineptly and inexplicably—to have undermined its own policy objectives: After announcing the withdrawal of the ₹500 and ₹1000 notes from circulation, the government decided to print a new version of the ₹500 note and to introduce a new ₹2,000 note. Not only did the Reserve Bank of India spend billions of rupees printing these notes, the new ₹2,000 note provided black economy operators an even better opportunity for storing illicit cash. Instead of making it more difficult to operate in large denomination notes, the government made it easier. India’s former Finance Minister aptly described the decision to introduce the ₹2,000 note as a “puzzle,” rightly asking, “How [is] the purpose of demonetization of high denomination notes  served if a new and higher denomination note is introduced?” I’ve not seen the Indian government offer any satisfactory answer to this simple question.
To be clear, on this point, the idea behind demonetization may well be sound, and could even be effective if implemented sensibly. For example, the European Central Bank (ECB) has decided to phase out the €500 note—one of the highest-value circulating notes in the world. This is not quite “demonetization” in the same sense as India’s policy, as even after the phase-out, existing notes in circulation would still be legal tender. But the motivation for the phase-out is at least partly the same, as phasing out the €500 note will make it more difficult to conduct large-scale transactions in untraceable cash. The ECB has taken a number of steps to smooth the transition and avoid hardship on citizens and businesses: the phasing out of the bill will take place over a two year period, and
On that note, it’s also worth observing—as many others have—that India’s demonetization policy imposed enormous social and economic costs on everyday citizens. The burden of the rapid and surprising removal of the ₹500 and ₹1000 notes fell less on corrupt officials and criminal organizations than on cash-dependent small businesses and poorer citizens, many of whom had to wait hours in line to deposit and exchange their notes. In fact, the sudden demonetization increased unemployment amongst poor laborers and resulted in the death of over 100 people, as hundreds of millions of citizens rushed to banks and ATMs to exchange their money. And perhaps unsurprisingly, declaring roughly 85% of India’s currency worthless—in an economy where 97% of retail transactions occur in cash—decreased the country’s GDP by more than two percentage points.
It appears that India’s demonetization has been a colossal failure as an anticorruption tool. That’s not to say that some forms of demonetization might not be a useful component of an anticorruption strategy. Efforts to remove large-denomination notes from circulation do indeed make illicit, unrecorded cash transactions harder to execute, and can be implemented in a way that minimizes disruptions to the legitimate economy. But the Indian government’s clumsy design and implementation of its policy maximized its disruptive effect while failing to meet its stated objectives. Perhaps part of the problem was the impulse to fight corruption with dramatic, headline-grabbing new policy initiatives, rather than through a sustained, multifaceted, long-term campaign. As one astute critic observed: “Public policy for rooting out corruption calls for a systemic approach, with carrots and sticks to motivate cultural, institutional, and behavioral change in the long term. Silver bullets, such as drastic demonetization don’t work.”