It should be a sudden and shocking decision
On November 8, 2016, Prime Minister Narendra Modi announced that all ₹500 and ₹1,000 banknotes (86% of the cash in circulation by value) would be demonetized. This sudden move exemplifies one of the most drastic economic tools a government can deploy. But what is demonetization?
What is demonetization? The demonetization process typically includes:
- Announcement by the government or central bank about which currency notes will be demonetized.
- Withdrawal of those notes from circulation from a specific date.
- Allowing citizens to exchange or deposit old notes at banks within a stipulated time frame.
- Introduction of new currency notes or coins to replace the demonetized ones.
Governments usually justify this drastic action by citing several objectives: Curbing Corruption and “Black Money”, Fighting Counterfeiting, Promoting a Digital Economy, and Reducing Tax Evasion. This article explores the gap between these objectives and the complex outcomes, using data from India and other nations to assess its true impact.
The Mechanics and Legal Framework of a Demonetization
Mechanics
In demonetization, secrecy is crucial. A limited time frame (e.g., a few weeks) is announced during which the old notes can be deposited or exchanged for new notes at banks and post offices. Limits are imposed to control chaos. Temporary exceptions might be made for certain critical services like hospitals, transportation, fuel stations and large supermarkets. Banking System Strain leads to banks and ATMs being closed for a day or two immediately after the announcement to recalibrate machines.
Legal Framework
In India, the 2016 demonetization was executed under a specific legal provision: Section 26(2) of the Reserve Bank of India Act, 1934. This clause states that, on the recommendation of the RBI’s Central Board, the Central Government may declare that any “series” of banknotes shall cease to be legal tender. The government followed this process, securing a recommendation, issuing a gazette notification, and implementing the policy immediately.
However, this very law became the center of a subsequent legal challenge. In the case of Vivek Narayan Sharma v. Union of India (2023), petitioners argued that the government had overstepped its authority. Their contention was twofold: They claimed that Section 26(2) was intended for a specific print run or series of notes, not for invalidating all notes of high denominations (which constituted 86% of the cash in circulation), an action they believed required full legislation by Parliament. In terms of proportionality, they argued that the immense economic disruption and the 52-day window for exchange were excessively disproportionate to the stated goals, inflicting undue hardship on citizens.
The Supreme Court’s judgment, however, upheld the government’s action. The Court essentially deferred to the executive’s judgment on economic policy, ruling that its role was to assess the measure’s legality, not to question its wisdom.
In Nepalese Contrast:
Under the Nepal Rastra Bank Act, the NRB possesses clear authority to demonetize currency. Section 60 grants the Bank the power to withdraw notes from circulation by providing reimbursement, following a public notice that specifies an exchange period. Crucially, once this period expires, the affected notes cease to be legal tender. Furthermore, Section 52(5) allows the Government of Nepal, upon the Bank’s recommendation, to restrict the validity of any denomination of banknotes to a specific place or office, providing another legal pathway for limiting a currency’s use.
Despite that the demoetization still creates a high-risk scenario. While a demonetization could be attempted, this would be an extreme political gamble. Interestingly, even if such an action were later invalidated though legal action, the practical effects – like the temporary influx of black money into the banking system – might still have good impacts, as a source of fund avaiable for investment, if not anything, facilitating the financial sectors.
Case Study: India 2016
What Happened? On November 8, 2016, Prime Minister Narendra Modi announced that all ₹500 and ₹1,000 banknotes (86% of the cash in circulation by value) would be demonetized.
Outcome
The move was highly disruptive to the cash-dependent economy. The data reveals a mixed picture:
|
Country (Year) |
Currency Affected |
Scale (Local Currency) |
Scale (USD Billion, Approx.) |
Primary Stated Goal |
Key Data-Centric Outcome |
Success Rating |
|
India (2016) |
₹500 & ₹1000 notes |
₹15.4 Trillion (86% of cash) |
~$230 Billion (at 2016 rate) |
Curb black money, counterfeiting |
99.3% of cash returned; GDP growth fell from 7.5% to 5.6%. |
Low |
The success was termed as low, because its primary stated objective was to curb black money and counterfeiting, although it could be seen as a success as money came into the formal monetary system as investible funds.
Transitory Loss in GDP
How demonetization affected GDP growth in India? GDP Growth Trends – quarterly GDP before and after demonetization.
- Pre-Demonetization (Avg for FY2017 Q1 & Q2): ~7.6%
- Demonetization Quarter (Q3 FY2017): 6.7% (A drop of nearly 1 percentage point)
- Subsequent Quarter (Q4 FY2017): 5.6% (The lowest growth rate in three years, showing the lagged effect)
- Recovery: Growth recovered to above 7% by Q3 FY2018, but it took a full year to surpass the pre-demonetization growth rates consistently.
Tax revenue trends
Did income tax collections increase post-demonetization? The number of individual income tax filers increased significantly, from about 40 million in FY2016 to over 70 million in FY2021. This expanded the revenue base for future public investment. India increased the number of individual income tax filers from ~ 40 million in FY2016 to ~ 70 million by FY2021. That’s about a 75% increase over ~5 years.
Potential for Tax Base Expansion: Under a moderate scenario, Nepal could potentially increase its number of individual income taxpayers from ~4.6 million now to ~8 million over 5 years if strong reforms are made. Correspondingly, income tax revenue might rise from ~NPR 150-160 billion now to NPR 300-350 billion in 5 years (i.e. doubling or more).
Comparing Global Perspectives
Compare with demonetization experiences in other countries (e.g., Nigeria 2023, Myanmar, Ghana, Soviet Union 1991).
Recent Demonetizations:
- Ghana: Demonetization of 2007 to combat inflation and counterfeiting.
- Zimbabwe: Demonetized currency in 2006 and again in 2015, abandoning its currency due to hyperinflation.
- North Korea: Redenomination of currency in 2009.
|
Country (Year) |
Key Data-Centric Outcome |
Success Rating |
|
Ghana (2007) |
Inflation fell from 10.5% (2007) to 8.4% (2009). |
High |
|
Zimbabwe (2015) |
Hyperinflation peaked at 79.6 billion %; adopted foreign currencies. |
Medium |
|
North Korea (2009) |
Led to hyperinflation and severe food shortages. |
Very Low |
Outcome
The move was highly disruptive to the cash-dependent economy. The data reveals a mixed picture:
|
Country (Year) |
Currency Affected |
Scale (Local Currency) |
Scale (USD Billion, Approx.) |
Primary Stated Goal |
Key Data-Centric Outcome |
Success Rating |
|
India (2016) |
₹500 & ₹1000 notes |
₹15.4 Trillion (86% of cash) |
~$230 Billion (at 2016 rate) |
Curb black money, counterfeiting |
99.3% of cash returned; GDP growth fell from 7.5% to 5.6%. |
Low |
The success was termed as low, because its primary stated objective was to curb black money and counterfeiting, although it could be seen as a success as money came into the formal monetary system as investible funds.
Number Analysis: What if it happened in Nepal?
Using India’s experience and using overly simplistic model of mirroring India’s ratios and , we can project potential impacts for Nepal:
|
Metric |
India 2016 Figure |
Projected Nepal 2025 Value |
Notes / Caveats |
|
% of Cash Demonetized |
~ 86 % |
~ NPR 585.24 billion |
~ NPR 680.51 billion in circulations |
|
% of Currency Returned |
~ 99.30 % |
~ NPR 581.6 billion |
Most of the demonetized cash comes back in deposits |
|
Demonetized Value vs GDP |
~ 11.50 % |
~ 11.5 %, i.e. ~ NPR 575 billion |
Equivalent ratio scale; depends on assumed GDP denominator |
|
Estimated GDP Loss (Short Term) |
~ 1 % of GDP / ~₹1.34 lakh crore |
~ 1 % of Nepal’s GDP |
~ USD 430 million in output loss |
|
Printing / Implementation Cost |
~ ₹12,000 crore (India) |
Estimated NPR 4-10 billion |
~ USD 28 – 70 million, rough scaling |
|
Additional Cash Inflow (Surge) |
₹3-4 lakh crore |
If scaled: perhaps NPR 400-600 billion |
Based on proportional scaling from India’s absolute demonetized amount |
|
Net Accretion to Bank Deposits |
~ ₹1.5-2 lakh crore |
Perhaps NPR 200-300 billion |
Depends on how much stays after normalization |
|
Sectoral / Supply Effects |
Informal/cash-intensive sectors hurt |
Effect is qualitative |
The shock could be relatively larger given higher informality in Nepal |
|
Short-Term Output / Employment Disruption |
Output fell ~3 pp in worst districts; overall ~1 % hit |
Could see sectoral output drops of 1-3 %; overall GDP dip ~ 0.5-1 % |
Depends on ability to substitute, buffer, etc. |
|
Recovery Trajectory |
Much adverse effect dissipated by mid-2017 |
Similar time-frame (12–24 months) |
But structural constraints, policy, institutional capacity matter |
The effectiveness of demonetization hinges on the starkly different capacities of urban and rural areas to cope. While India’s post-demonetization gains in taxpayers and digital payments relied on a shock to the system followed by rapid infrastructure deployment and enforcement, replicating this in Nepal would yield uneven results. Urban centers, with better existing infrastructure and financial literacy, could adapt more quickly. In contrast, rural areas, hampered by a lack of access, financial illiteracy, and weaker infrastructure, would be left behind without targeted integration policies. These would need to include practical measures like mobile exchange units, empowering local cooperatives as banking agents, and temporary relaxations of fees and KYC requirements to ensure the shock leads to inclusion rather than exclusion.
Conclusion and Verdict
The evidence from India and globally presents a clear picture: demonetization is a high-risk high-reward strategy. The primary goal of extinguishing black money often fails, as seen in India where 99.3% of the cash returned to the system. The short-term economic costs, in terms of GDP loss and public disruption, are significant and predictable.
However, the policy can act as a catalyst for secondary objectives like bringing investible fund into the formal monetary sector, expanding the tax base and promoting digital payments, as India’s 75% increase in tax filers shows. Ultimately, the success rating varies from “Very Low” in North Korea to “High” in Ghana, proving that context, execution, and underlying economic conditions are everything.
Dare it, do it !!