MUMBAI/NEW DELHI : Of all the initiatives of the National Democratic Alliance (NDA) government, none was as historic or dramatic as the decision to demonetize high-value currency notes. On 8 November 2016, in a televised address to the nation, Prime Minister Narendra Modi declared that all ₹500 and ₹1,000 notes, which together accounted for 86% of the currency in circulation, would no longer be legal tender. In India’s largely cash-based economy, this was a momentous decision.

Modi claimed that demonetization was needed to break the back of terrorism and corruption by eliminating black money from the system. “The magnitude of cash in circulation is directly linked to the level of corruption," said Modi in his speech on that fateful evening .

Three years on, none of these goals seem to have been met. Terrorism is as big a threat as it was three years ago, with the recent attacks in Gadchiroli and Pulwama continuing to expose our vulnerability to terror attacks.

Demonetization did bring down cash usage in the economy temporarily, but total currency in circulation has surpassed pre-demonetization levels. Even the cash-to-gross domestic product (GDP) ratio is inching back towards pre-demonetisation levels of 12% (Chart 1a/1b).

By Modi’s own yardstick (of cash in circulation), India seems to have gone back to being as corrupt a country as it was before November 2016.

As the queues continued to spill out of banks weeks after the announcement, demonetization began to take on new roles. Spokespersons of the government claimed that in addition to curbing black money, demonetization was an “economic reform" that was key to promoting digital payments and financial inclusion.

Though not mentioned in Modi’s announcement speech, these were the only two objectives which the board of directors of the Reserve Bank of India (RBI) were in agreement with the central government. In a board meeting held hours before Modi’s announcement on 8 November 2016, some directors on the RBI board expressed scepticism about the government’s claims about demonetization curbing black money and counterfeit currency. They observed that black money is not always held in the form of cash and that the ₹400 crore cited by the government as counterfeit currency is insignificant in comparison to the ₹17.7 trillion in circulation. Two years later, this was proven right when official statistics showed 99% of the demonetized currency notes had returned to the banking system.

Some RBI board members had also pointed out that there could be a temporary hit on growth. But the board still gave its assent to the move, ostensibly because it felt that demonetization would boost digital payments and incentivize people to use non-cash modes of payment, according to the minutes of that board meeting, accessed and made public by right-to-information activist Venkatesh Nayak.

However, even on digital payments, demonetization’s record has been bleak. Digital payments did spike immediately after demonetization, but since then, growth has subsided to pre-demonetization levels. This suggests the spike was just a reaction to the immediate cash shortage and did not have a lasting impact on people’s transaction behaviour (Chart 2).

The overall usage of digital modes of payment rose 10 percentage points between 2014 and 2017 to 29%, according to data from the World Bank’s Findex database. Yet, this is much less than the average usage of digital payments across the 10 largest emerging markets, which stands at a little above 50%. The Findex database is based on a global survey of 150,000 people across 144 economies of age 15 years and older. In India, 3,000 people were surveyed between April and June 2017 for the last round.

None of the large economies, which surpass India in digital payments, had to go through the painful experience of demonetization to boost cashless transactions. What they did experience, though, was a systematic boost to the infrastructure for digital payments. In terms of digital infrastructure, India did see a sharp increase in point-of-sale (PoS terminals) and the number of credit cards post-demonetization (bit.ly/2VKosdD). But the latest data from the Bank for International Settlements shows that as of 2017, India did see a sharp increase in point-of-sale (PoS) terminals and automated teller machines (ATMs) among G-20 economies (Chart 3).

Research suggests that a denser and reliable ATM network reduces people’s tendency to withdraw cash in large amounts, which helps boost cashless payments. More PoS terminals can also help.

The shift to a cashless economy needs to be supported not just by the digital payments infrastructure, but also general awareness and by addressing the apprehensions of people. A recent research paper from Jaipur showed how merchants fully equipped for digital payments struggled to shift to digital transactions because consumers continued to prefer cash, owing to concerns regarding tax liability. Demonetization may have forced people to temporarily use digital payments, but it does not seem to have led to attitudinal changes.

Finally, most countries that have greater use of cashless transactions are also richer than India (in terms of per capita income).

Economies that have reduced the use of cash have all adopted one of these methods: reliance on economic growth or a boost to digital infrastructure (along with technological innovations). No country on Earth has had to demonetize 86% of its currency in circulation to boost digital payments, as India did in 2016.

Another related defence of demonetization, put forward by the Economic Survey of the finance ministry, was that the force of demonetization would drag more Indians into the tax system. Capturing this effect on the tax base is trickier to measure. While India’s tax-to-GDP ratio has increased in the last couple of years, this increase is not unprecedented, and could be a result of a number of factors.

It is entirely possible that demonetization was partly responsible for the boost in tax collections in the year following demonetization, as it led to a temporary spurt in people filing tax returns for the first time. However, latest data shows that the growth in the number of people filing tax returns has not sustained, with the number of people filing returns shrinking in 2018-19 compared to the year-ago period .

The Indian Express reported that while demonetization may have led to a spike in new taxpayers, it also led to a historic rise in the number of people who stopped filing taxes, perhaps because of loss of jobs or income that year.

Demonetization may have failed to attain any of its stated goals, but it did disrupt life and economic activity. The cash crunch meant that GDP growth fell immediately in the quarter of demonetization (Q3 2016-17) and the slowdown persisted in subsequent quarters. According to one paper by International Monetary Fund chief economist Gita Gopinath and others, the resulting crash crunch shaved 2 percentage points off quarterly economic growth. While official statistics suggests that the growth hit was only temporary, Gopinath and others argued that official estimates do not capture the informal economy and, hence, can be misleading. A World Bank study based on night light data shows that districts with a higher proportion of the poor and unbanked were hit harder by demonetization (Chart 4).

Micro, small and medium enterprises (MSMEs) were hit the hardest as they run on cash. The sector which was already facing a credit crunch saw a further decline impacting output and export growth, according to a research paper by economists at RBI.

“Demonetisation led to a further decline in the already decelerating credit growth of the MSME sector, while GST implementation does not seem to have had a significant impact on overall credit to MSMEs," said the paper. GST stands for the goods and services tax.

Rural consumer sentiment too took a hit, with domestic sales of two-wheelers plunging sharply in the months following demonetization. Car sales also fell but the decline was less severe than in the case of two-wheelers.

Although an economic failure, demonetization was perhaps a political success story. In fact, post-poll surveys by the Lokniti-Centre for the Study of Developing Societies team in four states—Goa, Punjab, Uttarakhand and Uttar Pradesh—that went to polls in the months following demonetization showed that a majority of voters supported the note ban even though they suffered from it.

Many voters may have felt that others, more wealthier than them, were also being hurt by demonetization, and hence supported the adventurist move.

The results of the second round of the YouGov-Mint Millennial Survey conducted in early 2019 suggest that even today and, despite all the evidence to the contrary, many urban youths who support the ruling party consider demonetization to be a great success of the government.

That fact is as sobering as the fact that demonetization failed to meet its objectives.

This is the concluding part of a 12-part report card series on the NDA-II.

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