No rupees left behind

Data on the world's biggest monetary event of the 21st century—Narendra Modi's demonetization—continues to trickle in. The Reserve Bank of India's just published its annual report (pdf) and I'll just say this straight out—I'm genuinely surprised. Out of the ₹15.44 trillion in paper currency that was demonetized by Modi last November, ₹15.28 trillion, or 98.96%, have been returned. My guess would have been that a much smaller proportion of India's monetary stock made it back to the RBI, maybe 92-95%.

For those not familiar with rupee prices, I'll translate the above numbers into US dollar terms. Back on November 9, 2016, $240 billion worth of rupee notes were declared to be invalid. By June 2017, only a small 1.04% sliver of this—$2.5 billion—was still unredeemed, far less than the $15-30 billion many of us though would have been left stranded. (I'll use dollars from here on since it is easier for the international community to understand.)

A glance at the stranded notes counts from a the euro changeover provides some context. When the Euro was introduced in January 2002, people were given fixed windows of time to redeem existing national banknotes before their money status was revoked. In the case of the Italian lira and French franc, individuals had till December 2011 and February 2012 respectively to bring in their notes for euros. By the time this ten-year exchange period was over, 99.15% of Italian lira had been returned while 98.77% of French francs made it back. Much of the unreturned 1% would have been withheld by the collecting community, the rest either being lost, buried, burnt in fires, or destroyed in floods.

Whereas the French and Italians had years to diligently round up old notes before the window closed, Indians only had few weeks, the final day for exchanging being December 31, 2016. Yet even with this much smaller window, Indians were able to bring in greater portion of the outstanding money supply than the French did in ten years. Impressive. Are Indians just great at locating things? Or is something else to explain? The skeptic in me wonders how many counterfeit rupees managed to make it passed the RBI's gatekeepers. No central bank can perfectly screen for fakes—so if the RBI mistakenly accepted a greater proportion of counterfeits than the Bank of France did, then the return rate on rupees would have been artificially improved relative to that of francs. But I'm just speculating.

What makes the final 98.96% return rate even more incredible is that, unlike the European demonetizations—which allowed unlimited, no questions-answered redemption—the Indian demonetization imposed per-person ceilings on the amount of rupees that could be freely converted into new paper rupees. Anything above the ceiling had to be deposited into a bank account i.e. individuals would be de-anonymized and potentially investigated. Yet even with the imposition of such a severe threat, a greater portion of rupees were redeemed in the waning days of 2016 than French francs during the entire 2002-2012 period.

Jugaad, or Indian ingenuity, is one of the explaining factors. Even though they had just a few weeks, Indians who had large quantities of illicit cash were able to contract with those who had room below their ceiling to convert illicit rupees on their behalf, thus evading Modi's blockade. This was money laundering on a grand scale.

There is a second explaining factor for the high return rate. Two weeks after the initial demonetization announcement, the government introduced a formal amnesty for demonetized banknote holders. Any deposit of cash above the ceiling would only be taxed at 50%, assuming it was declared. If not declared, the funds might still get through the note blockade undetected, although if apprehended an 85% penalty was to be levied. These new options were better than throwing away one's stash altogether and suffering a sure 100% loss, so previously reticent citizens would have flocked to bring their notes in, even if they had been amassed illicitly.

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Demonetization was designed to provide a "national dividend" of sorts. If just 90% of the demonetized rupees had made it back to the central bank, the remaining 10% would have been written off, the one-time profit providing a massive $24 billion dividend to all Indians (participants in the underground economy being the folks who funded this subsidy). Does the higher-than-expected 98.96% return rate for rupees mean that Modi's demonetization has failed as a mechanism for redistributing funds from large participants in the underground economy to the rest of the Indian population? Is the national dividend void? Not at all.


As I wrote above, many of the demonetized rupees that have made their way back into the system were deposited into bank accounts. Some depositors will have sought shelter under the 50% amnesty. For the remainder, authorities will be following the paper trails left by deposited currency over the next few years and, if warranted, levy a tax on these deposits. This is a more cumbersome way to collect a tax than stranding banknotes because it requires investigating each suspicious deposit and potentially prosecuting the depositor. It remains to be seen how successful the Indian authorities will be in collecting this tax. Jagdish Bhagwati explains this all in far more detail here.

Remember the ingenuity that Indians used to escape the ceilings that were imposed on them? This was also a form of redistribution. Rich Indians would have paid poor Indians—who had plenty of room under the ceiling—a fee to deposit notes on their behalf, say 25%, or ₹250 on a ₹1000 note. Together, all of these fees would be very much like the national dividend described in the above paragraphs. Except rather than the tax being collected by the authorities and then paid out as a dividend, it would have been collected directly by Indians themselves. If $25 billion was laundered in this way, and an average fee of 25% charged, a $6.25 billion dividend would have been collected by poor Indians from rich ones.

In summary, a large chunk of stranded rupee notes would have provided the 'cleanest' way of taxing to fund the national dividend. However, the fact that very few notes were stranded doesn't mean there will be no national dividend whatsoever.