India has been serving as a real-world financial laboratory for the past two months.
I doubt this was the initial intent, and I doubt wide swaths of the Indian population relish having been cast in the role of unwitting test subjects.
Nonetheless, at this point it’s worth assessing the lessons learned from the country’s radical move on cash use.
On Nov. 8, Prime Minister Narendra Modi unveiled a surprise to rival the U.S. election result that followed just a few hours later: He announced a banking holiday, declared all 500 and 1,000 rupee notes in circulation to be null and void, and required these paper notes be exchanged for new tender.
For Modi, a reform-minded leader with a reputation for bold moves, this was perhaps his boldest stroke yet.
These notes, India’s largest denominations (essentially the equivalent of $7.50 and $15) comprised 86% of all cash in circulation.
The concept was straightforward: India’s cash-heavy economy is widely viewed as plagued with “dark money” used to enable off-the-books transactions that do not generate sorely needed tax revenues.
Flushing this currency from the system would strike a blow against illicit trade while generating government revenue without raising tax rates.
The operation had to be a complete surprise. Otherwise, gray economy operators could simply launder their cash.
The “shock and awe” aspect of the process was accomplished—though perhaps not in the form intended. Long queues persisted for weeks once banks reopened, in part because new-model currency production lagged demand.
Notes had to be exchanged in person in small batches—a process akin to U.S. anti-money laundering rules requiring disclosure of cash transactions exceeding $10,000, although limits were far lower in India.
In addition to the unproductive downtime lost standing in line, there are signs India’s overall economy took a hit as commerce slowed for the lack of cash. Imagine in the U.S. if ATMs became temporarily obsolete because $20 bills were useless—then consider that India is far more cash dependent than the U.S.
There were unconfirmed tales of businessmen raiding their kids’ piggy banks for “walking around” money to cover transport, tips, and the like.
Substantiated reports surfaced of barter systems coming back into vogue in rural villages.
A U.S. colleague told me media tales of disruption were overblown. His contacts in India reported minimal personal impact, having long ago migrated to cards and mobile payment devices.
While this may hold true among certain demographics, it fails to account for the impact in a country with a sub-20% smartphone penetration and card use nowhere near U.S. and European Union levels.
Necessity is the mother of invention, as the saying goes, and The Great Currency Exchange of 2016 had its share of side effects—good and bad.
For those with tech access, a clear spike for established mobile commerce solutions like Paytm and newfound traction for startup alternatives signaled a permanent reset, adding convenience to (and removing cash from) India’s payments system.
On the downside, holders of dark money apparently found avenues to game the system. Stories were rife of companies and rich individuals deputizing employees (or simply hiring jobbers) to stand in line to exchange the legal cash limit.
Then there are “Jan Dhan” accounts, the entry-level banking vehicle created to foster financial inclusion.
Aggregate balances in these accounts surged 60% in the two weeks following the announcement. Hmmm, I wonder where this new money might have come from…
By the time the exchange window closed Dec. 30, more than 95% of 500 and 1,000 rupee notes had been converted.
On one level this is a sign of successful closure. On the other, it must be a higher percentage than the government anticipated, and implies that a fair bit of dark money was converted and consequently legitimized.
Still, given India’s central bank’s reported plans to reissue only half as much paper currency, more future transactions are likely to be above board and taxable.
With the worst of the pain behind them, reformers are confident the ongoing benefits (more tax revenues, a more efficient payments system) will be well worth the 52 days of turmoil.
Time will tell. In a few months we’ll be able to quantify the hit to India’s fourth-quarter gross domestic product (GDP).
It will be longer before we understand the ongoing effects. As an Indian-born U.S. resident explained to me, even affluent consumers with credit cards are conditioned to buy luxury items like jewelry with cash.
Old habits die hard. Will such discretionary spending see a permanent haircut?
It’s hard to envision U.S. policymakers enacting similarly draconian, centralized measures. But in light of recent Federal Reserve research confirming the ongoing relevance of cash and checks, as we continue our march toward the vision of a paperless society it’s important to consider the Law of Unintended Consequences.
Cash is the basis for “only” a third of U.S. financial transactions (versus 98% in India).
However, when unexpected GDP swings of 0.3% can move markets, this figure should still give pause.