How many rupees are printed per year

Cash: That brought India's big money experiment

Frankfurt On November 8, 2016, not only Donald Trump was elected President of the USA. It was also the day on which India’s Prime Minister Narendra Modi announced a gigantic money experiment, completely surprising.

With almost immediate effect, he forbade the continued use of the two largest banknotes of 500 and 1,000 rupees with a value of around seven and 14 euros as a means of payment. Owners had to pay them into an account at banks - in the case of larger quantities, with proof of their origin. This means that 86 percent of the cash in circulation was withdrawn from circulation.

The central bank issued new bills worth 2,000 rupees each. But it took a long time to get them printed and distributed. For many purchases they could not be used due to the lack of change.

There was extremely little cash in circulation for weeks. It took months for the situation to normalize to some extent. In the beginning, hundreds of millions of people had to wait in long lines in front of bank counters for days instead of being able to go about their work.

If you believe the official statistics, then none of this had any effect on the economy. In March 2017, the statistical office announced economic growth in the fourth quarter of 2016 of seven percent compared to the same quarter of the previous year. Even if you factor out the sharp rise in government spending in the quarter, the growth rate of six percent was only a good half percentage point lower than in the same quarter of the previous year.

Insufficient statistics

But four economists from Harvard University, Goldman Sachs and the Indian central bank Reserve Bank of India (RBI) have now shown in the essay "Cash and the Economy: Evidence from India's Demonetization" that the damage to the economy is great was bigger.

The four explain why the demonetization hardly left any traces in the official statistics by the fact that 90 percent of India's economic output is generated in the informal sector and is therefore not statistically recorded.



of the cash in circulation in India were suddenly no longer valid on November 9, 2016. Source: Reserve Bank of India

This part of the economy is particularly dependent on cash. An estimated economic output of the informal sector is included in the reported gross domestic product - but for years with the same amount, only updated according to trends.

Instead, the economists used three alternative indicators for their study. All pointed to a “sharp and economically significant drop in economic activity” after the demonetization. The first indicator was a large nationwide survey on employment. The second was satellite images of nighttime light intensity. And the third indicator was bank lending.

In order to quantify the extent of the economic damage and to verify the cash shortage as the cause, the economists broken down the corresponding data by region and compared the change with the regional differences in the extent of the cash shortage. For logistical reasons, the new cash from the central bank arrived at different speeds in the ATMs and banks in the various regions.

The authors come to the conclusion that Indian economic output shrank in the last quarter of 2016 compared to the third quarter and that the quarterly growth rate was at least two percentage points lower than without the drastic money experiment.

Is that much? On the one hand yes, write the economists, on the other hand it is only a fraction of the 86 percent cash shortage. People have found alternatives, be it card payments, mobile payment systems or the good old cover letter.

Since above all the better off and the companies in the formal economy had good alternatives, but hardly the poor, migrant workers and small businesses in rural areas, the economic damage is likely to concentrate on the latter.

Forcing people to switch to digital payment methods was one of the declared goals of the campaign, even if not from the start. At the beginning, the government had stated that the aim was to flush illicit money out of the system and to combat counterfeiting, tax evasion and terrorism.

A few weeks later, the promotion of “financial inclusion” was added as a further goal. According to the World Bank, the idea behind this is that all people, especially the very poor, have access to commercial financial services and should use them regularly.

According to data from the central bank, only 0.7 percent of the invalidated banknotes were not exchanged within the deadline. The black money holders evidently found ways of legalization. For many others, however, the increased transparency had bad consequences. Domestic violence cases shot up in November as women who hid cash from their husbands were forced to reveal their secrets.

Very soon there was no longer any talk of the fight against terrorism, but then all the more of the modernization and digitization of India and of “financial inclusion”. Modi himself worked intensively as an advertiser for mobile payment methods.

No money for an account

Hasina Daya and Philip Mader from the UK Institute of Development Studies examined the impact of cash withdrawal on “financial inclusion”. They compared the data for India from the World Bank's Findex database of financial services usage from 2011, 2014 and 2017 to see if there was a break in the data.

The number of accounts rose sharply between 2014 and 2017, but it had already done so from 2011 to 2014. However, many of the accounts are almost or not used at all. Although well over half of Indians have a bank account, only 20 percent said they would save with a financial institution in 2017, a modest six percentage points more than three years earlier. Only seven percent borrowed from a financial institution. That was less than in 2014 and even than in 2011.

The proportion of those who stated that they had already received or initiated a digital payment rose from 19 to 29 percent between 2014 and 2017. But in a certain contrast to the euphoric success reports of the providers and the advertising by the Prime Minister, the proportion of those who had a mobile money account fell from 2.4 to 2.0 percent.

The reasons were easy to find: Over half of the participants in the Findex surveys said they had too little money to use an account; over a quarter said it was too expensive; a quarter were missing the necessary documents and a fifth did not trust the financial institutions.

The authors' conclusion: "In a country where many people are worried about the next family meal and cannot afford education and sanitation, the problem is bypassed when the government prioritizes financial services."