April 26, 2023

What is Demonetisation in India - Meaning, Date & Effects

On the 8th of November, 2016, India’s Prime Minister, Narendra Modi, took active steps to put INR 500 and INR 1000 notes out of circulation with immediate effect, thereby bringing into effect demonetisation.

By demonetising these bills, he took away the legal tender or stripped away their legal status in the Indian economy. People were given until 31st December to exchange these notes or deposit the money into their accounts. As per RBI, these notes accounted for 86.9 percent of the total notes in circulation.

Demonetisation is not new and has been previously done by several nations to positively change the liquidity structure or counterbalance the ongoing economic conditions. In India, demonetisation was done to curb counterfeiting and money laundering.

Let us understand more about demonetisation in India and its effects in the sections below.

A Brief History of Demonetisation

Demonetisation is withdrawing money from circulation or general use. The idea is to replace the old currency with a new one. The bills' new denomination can be either the same or higher than the previous one.

In India, it was accomplished twice before 2016. The first demonetisation event occurred in 1946 when the notes of INR 1000 and INR 10000 were removed from the economy. As these bills were of a higher denomination which the average public did not have, the impact of this demonetisation was low.

These notes were again introduced in the Indian economy in 1954. Moreover, an additional denomination of 5000 was also circulated at the same time.

The second event of demonetisation happened in 1978. The then Prime Minister, Morarji Desai, had demonetised higher denomination notes of values INR 1000, 5000 and 10000 through an announcement on the radio. The purpose was to reduce the circulation of black money in the Indian economy.

As seen above, these instances of demonetisation did affect the economy. So, why did the Government undertake this process again in 2016? The section below discusses various aspects related to the same.

Driving Factors for Demonetisation in 2016

When demonetisation took place in 2016, the government gave two reasons: to seize the black money or undeclared income in the economy and to keep a check on counterfeit currency. While the first reason would help control corruption, the second was an attack on terrorism and its associated activities.

In the subsequent days, the government gave additional areas where demonetisation would prove to be of help. Firstly, the authorities declared that it would help digitise the economy and make it less reliant on cash. Secondly, it would help bring some structure to the large informal sector in India.

In addition, the government also said that demonetisation would push India to become a modern digitised economy, which would be less reliant on cash. More digital payments would organise a large share of the informal and unorganised Indian sectors. Finally, it was a move that would remove unaccounted money from the economy and increase the tax base.

Now that we know the reasons that led to demonetisation in 2016 let us see what the government said about the event later.

Indian Government's Take on Demonetisation

The Ministry of Finance published a statement on August 30, 2017, declaring the success of demonisation. Here are some of the areas where the government highlighted with regards to the effect of the same mentioned below:

The government said it successfully curbed black money in circulation due to demonetisation.
The RBI was able to recall Rs. 15.28 lakh crore worth of notes from circulation as of 30.6.2017. The outstanding SBNs or Specified Bank Notes as of 8th November 2016 were valued at Rs. 15.44 crore. The Indian banking system succeeded in this humungous challenge of collecting such a large sum from the public. The remaining amount represented the unexplained or black money in the economy. Also, the effective currency in circulation in August 2017 was only 83%, with full demonetisation having taken place.
Using innovative data analytics tools, 2.89 lakh crore in cash deposits became the subject of inquiries, and 5.56 lakh more suspicious cases were discovered.
The event led to an extraordinary rise in tax compliance. Besides the 56 lakh additional tax filers, there was also an increase of 24.7% in the number of returns filed compared to the previous year. There was a 41.79% increase in advance tax collections for personal income tax and a 34.25% growth in self-assessment tax (SAT) during the same time.
Demonetisation helped in removing transactions of over 3 lakh allegedly fraudulent shell companies.
Over 400 defaulter transactions were discovered by the Income Tax Authorities, with the market value of the properties attached totalling more than Rs 600 crore.
2.24 lakh shell companies were deregistered. 450 companies were de-listed, 800 untraceable companies were untraceable, and the government delisted them.
When banks have more money, it leads to a drop in interest rates, allowing more borrowing and better development opportunities. Demonetisation led to increased banking system deposits to Rs. 3 lakh crore and a 100 basis point drop in interest rates because of additional liquidity.
From 71.27 crore transactions in October 2016 to 111.45 crore transactions in May 2017, digital payments increased by 56%.
It hampered the circulation of fake currency since it was soon extensively examined. Also, the new notes were of a different make and design, making it tougher to create their copies.
Control over the surplus cash flow out of the banking sector of India.
Approximately 99.30% of the devalued Rs 500 and Rs 1,000 notes were back in circulation as of August 30, 2018.
Following demonetisation, over one crore workers were enrolled in the EPF and ESIC systems. About 50 lakh people created bank accounts so their earnings could be deposited straight into those accounts.
In 2016–17, exports increased at the fastest rate, by 4.7%, reaching $274.65 billion. Exports increased by a staggering 27.6% to $29.23 billion in March 2017.
After demonetisation, there has been a 400%–1000% surge in digital transactions.
The RBI reported deposits increased by around Rs 6 trillion. The increase in bank deposits has caused banks' lending rates to decline.
Lesser liquidity in the market helps in arresting inflation. For a few months after demonetisation, food inflation dropped to 1.37%. Therefore, inflation slowed down the most during and after the demonetisation year.
The Economic Statistics Database reported that India's GDP climbed by 7.494% in 2017 to $2,487.94 million. PAT estimates the GDP to be $9.6 trillion. GDP is rated third globally when measured in Purchasing Power Parity (PPP) and sixth when measured nominally.
IIP for January 2017 increased by 2.7% despite the effects of demonetisation.

Despite these figures, we also know that demonetisation was an event that led to a vast public outcry. As it impacted the general public, a section heavily criticised this move. Let us understand the consequences of demonetisation.

Demonetisation In Review

Almost six years after demonetisation, we have enough statistics to analyse whether it was successful or not. Many of us vividly remember standing in long queues that night to withdraw some cash to get by in the following days. Was this move worth it?

Let us understand this by analysing the positive and negative effects that unfolded after demonetisation.

Positive Effects of Demonetisation

It pushed the use of digital platforms for carrying out transactions. Of course, the covid pandemic further helped establish online payments as a preferred mode of payment in the Indian economy.

UPI transactions more than doubled to 84.16 lakh crores this year as compared to 41.04 lakh crores last year. Today, we can safely say that it paved the way for making India a cashless economy.

With the use of digital payment systems, by the end of January 2017, just two months after demonetisation, the cash went down to 8 lakh crore. Businesses of all sizes went digital using digital apps, electronic payment methods, and digital wallets.

One of the main benefits of digital transactions is that it makes tracking cash flow much more straightforward.

After demonetisation, the detection of fake currency notes also spiked in the country. As per RBI data, 317,567 counterfeit notes of INR 500 and 256,324 fake notes of INR 1000 were detected in the baking system. These figures compare to 261,695 and 143,099, respectively, in the previous year.

Demonetisation also helped in income tax collections which increased by 15% and 18% in the two years after the event. In the two years before demonetisation, this growth was 6.6% and 9%, respectively.

The other macroeconomic impact of demonetisation**,** as studied by RBI, is available here. Whether demonetisation helped arrest corruption is something we need to contemplate as such individuals have assets other than cash that accounts for their wealth. However, the move temporarily affected the counterfeit money used in terrorism as the currency was declared null and void.

Demonetisation helped in widening the taxpayer base of the country. This is the money that gets used for governance and providing better facilities to the citizens. India had only 55.9 million taxpayers during 2015-2016, and Government added 9.1 million new taxpayers in 2016-2017, indicating an increase of over 80%. At that point, tax revenue growth enabled the government to offer loans with significantly lower interest rates.

Negative Effects of Demonetisation

Despite the long-term advantages, demonetisation had some short-term drawbacks, including creating a panicky atmosphere among the public. Moreover, it had a variety of effects on the economy.

The analysis of demonetisation is incomplete without studying the cost that the country had to pay. Taking out the existing notes from circulation and bringing new notes was expensive. According to data, RBI spent approximately 13000 crores on new note printing in 2016–18.

Moreover, the RBI lost money for paying dividends to the government after demonetisation. The data here proves this fact.

During 2015 -16: Dividend of Rs. Rs 65,876.
During 2016 -17: Dividend of Rs. 30,659 crores.
During 2017-18.: Dividend of Rs. 50,000 crores.

Demonetisation is one of the notable occurrences in the economic history of India since it changed the country’s currency liquidity, which altered consumption, production, employment, and other factors. The major ones are highlighted below.

Lack of Working Capital

Demonetisation caused a cash scarcity, which led to a lack of working capital in the manufacturing sector, which resulted in mass layoffs. The problem was more pronounced in the informal sector. As these are the businesses where the transactions are mostly done in cash, it affected people's earnings. The earnings were in cash, and suddenly there was no liquidity for the business owners to pay.

Daily Wage Laborers Lost Primary Source of Income

The currency shortage directly affected millions of daily wage earners, labourers, and small business owners who were suddenly cash-stripped. To cut their losses, businesses had to lay off their staff, including this section of society that survives on daily wages. Monitoring Indian Economy estimated that 1.5 million jobs were lost due to this episode.

Agriculture Sector

Demonetisation impacted the agricultural sector as prices decreased and did not give the farmer good returns.

Low GDP Income

The growth percentage of the GDP declined by 0.5 percent.

Decline In Industrial Production

Demonetisation resulted in a modest 0.4% decline in industrial production for December 2016.

Increased Consumer Price And Consumer Price Index

Since November 2014, December 2016 saw the smallest increase in consumer price growth—3.41%. In March 2017, the consumer price index rose by 3.81% year over year, which was less than the market expectation of 3.98%.

50 Lakh People Lost Their Jobs

The State of Working India reported that the Indian unemployment rate rose to 6% between 2011 to 2016 and at least 50 lakh people lost their jobs after demonetisation.

Generated Questionable Transactions

In the years following demonetisation, the government discovered only Rs. 16,000 crores of hidden black money. More than Rs. 14 lakhs of suspicious transactions were generated due to demonetisation.

In Summary

Although the currency demonetized by the Indian Government may have changed, the main objectives remained the same: to shorten illegal activity, manage inflation, eliminate counterfeit money from the economy, and draw unaccounted money to the attention of banks and tax officials.

Demonetisation was touted as one of the most significant and boldest steps any Indian government has taken to counter terrorism in the country. Although the immediate days following the event were chaotic, the Indian banking system rose to the occasion and managed to collect a considerable amount of currency in the economy.

Frequently Asked Questions

What Was the Motivation Behind Withdrawing the 500 and 1000 Rupee Old Bank Notes as the Legal Tender Scheme?

Demonetisation is eliminating specific types of money from users. Fake Indian rupee notes of higher denominations had become increasingly prevalent in the economy. Fake currency is one of the main tools used for illegal and anti-national activities. As counterfeit notes are printed using advanced technology, people may be unable to identify them.

The Indian economy was still primarily based on cash in 2016. Hence, the threat posed by fake Indian currency notes was high back then. The Government of India launched a plan to remove the legal tender status of the old banknotes in the denominations of 500 and 1000 to fight the rising frequency of fake rupee notes and black money.

What Did India Gain From Demonetisation?

Since demonetisation, digital transactions have drastically increased in India. The number of UPI transactions rose to 7.3 billion in October 2022 from 4.2 billion in October 2021. Higher digital points meant printing fewer notes by the RBI and ease in tracking financial transactions. This resulted in saving the cost of printing money for the Government of India.

How Can India Stop Black Money?

Demonetisation has been the favoured method recognized to reduce black money. Apart from demonetisation: raids, rigorous taxation reforms, and voluntary disclosure schemes are some methods that help reduce black money.

What Is the Maximum Amount We Can Draw From an ATM?

The Government of India has lifted limits on ATM cash withdrawals as of February 1, 2017. Before November 8, 2016, banks could set operational restrictions of their choice on the cash withdrawal cap for an account. But now, the withdrawal limits range from Rs.10,000 to Rs. 25,000 depending on the card type.