Demonetisation continues to bewitch its supporters and baffle its critics. But neither lot has yet come up with tenable explanations of the origins of the policy. Given the magnitude of its impact, it is not surprising that any number of conspiracy theories are doing the rounds. Among the more curious of these is the claim that behind demonetisation lies a “foreign hand"—actually a set of hands. According to this meme, the policy was the brainchild of a digital payments cabal led by USAID and consisted of sinister American philanthropies as well as companies.

This tendency to discern American fingerprints around our woes is an old one. Few recall, however, that the US actually bailed out India during one of its worst currency crises: in World War II.

The crisis stemmed from the manner in which Britain financed India’s war. Instead of paying New Delhi in real time for its material and military contributions, Whitehall deposited IOUs in an account in London. These “sterling balances" were then shown as assets on the Reserve Bank of India’s balance sheet and used to expand money supply. The Reserve Bank of India (RBI) had been around for just about eight years and its first Indian governor, Chintaman Deshmukh, acquiesced in this cranking up of the printing presses. Not all Indians on the RBI board agreed, but that’s a story for another day.

This extraordinary monetary expansion led to galloping inflation, with devastating consequences for India, including famine. Because of soaring inflation, the people also began hoarding silver coins and distrusting paper currency. Silver coins came in three denominations: 1 rupee, 8 and 4 annas. The RBI and the government were already keen to move from silver to paper currency. The RBI governor, James Taylor, advised the government to “take the opportunity of the war to liberate Indian currency as far as possible from the incubus of silver, a metal which does not seem to have any future before it".

So, the RBI initially sought to meet the demand by introducing a new Rs2 note and then a new Rs10 note. But this did not help much as most transactions happened on smaller denominations. The lack of small change, a report noted, was “disrupting retail trade and causing suffering to the poorer classes…resulting unrest might cause serious disturbances". Silver (like gold) was also traditionally regarded as a store of value and hedge against inflation. Hence, people were not just hoarding silver currency but, in many instances, melting it into bullion.

Soon the RBI needed more silver for coinage than was available in the country. It was estimated that starting in March 1944, they would require four million ounces per month of silver for coinage. Further, to prevent people from melting silver coins, the Indian government proposed to build up a larger stock of 100 million ounces, which could be sold on the market to limit and control the price of silver. In this context, India turned to the US for help.

In early June 1943, the government requested the US Treasury to supply under lend-lease 100 million ounces of silver for the stock as well as 20 million ounces for coinage. India proposed to return an equivalent amount at the end of the war.

While the US Treasury was prepared to approve this request, the state department opposed providing to India the additional 100 million ounces of silver. “Any silver for this purpose", it insisted, “should be lend-leased to the British Government and not to the Government of India."

The British and Indian governments insisted that the matter was “really and increasingly urgent". They pointed out India’s “grave economic difficulties" and the “grave blow" that would be dealt to the common war effort. But the state department refused to budge.

American officials held that the political future of India was unsure. It was quite likely that after the war “a violently nationalistic government made up of Indians themselves might gain power". Hence it would be “rash" to assume that such an Indian government would voluntarily agree to return the silver.

The American position enraged Indian officials. K.C. Mahindra, chief of the supply mission in Washington, told the state department that he was “astonished and distressed" and that it was “an insult to his country". The Indian agent general, Girija Shankar Bajpai, pointed out that owing to India’s accumulation of sterling balances, it was now a creditor vis-à-vis Britain. The Indian people would be “particularly resentful" of the American refusal to provide the silver directly.

Faced with this robust reaction from the Indians, senior state department officials decided to compromise. They now proposed that while the silver would be loaned directly to India, it should be jointly guaranteed by the British government. Despite appeals from London and New Delhi, Washington refused to relent. The British eventually agreed to sign a separate bilateral agreement with the US undertaking responsibility for the return of silver.

And so the agreement was sealed—much to the chagrin of Indian officials. Nevertheless, they recognized that without American silver the currency crisis would have spiralled out of control. It would also have destroyed the RBI’s standing.

This episode reminds us that it is pointless to blame outsiders for our problems with currency. They may even help on occasion. As we attempt a huge shift to yet another form of payment, it is the credibility of the RBI and the government that matters the most.

Srinath Raghavan is senior fellow at the Centre for Policy Research, New Delhi.

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