From India's Demonetization to Digitalization

By: Malvika Govil

On November 8th, 2016, Indian Prime Minister Narendra Modi unilaterally decreed a nation-wide ban on 500 and 1000 rupee notes, sending millions of Indians scrambling to swap them for the newly-minted legal tender. The demonetized notes comprised no less than 86% of India’s total money supply. Initially rolled out as a scheme to combat the use of counterfeit cash for terrorism, demonetization was later touted as a “surgical strike” against black money and corruption, and was most recently promoted as a push towards a cashless economy.

While demonetization has undermined counterfeit money for the time being, its two other broad goals to tackle corruption and tax evasion have not been fulfilled. Black money, meaning money earned through illegal activities or money that has evaded taxes and other untaxed sources of income, is perceived to be the consequence of rampant corruption among rich businessmen, bureaucrats, and politicians - it is an issue that has sparked massive public outrage and political transformation in the last few years. As a byproduct of the informal ‘shadow’ economy, “black money” is viewed by the public as secret stashes of cash, hidden under mattresses and in personal safes. Thus, Modi’s government piggybacked a 50% tax penalty on previously undeclared cash income in accordance with demonetization. With these measures, Prime Minister Modi claims to be tackling corruption and tax evasion in India.

However, Modi’s policy shift has resulted in sudden and severe short-term consequences because India is one of the world’s most cash-driven economies - the only one, in fact, where Uber allows cash payments. The cash crunch caused a plunge in consumer demand that temporarily wiped out the revenue streams of millions of India’s daily wage earners, devastating the livelihoods of small business owners, farmers, and the poor. The informal economy is built on cash transactions and is largely comprised of the agriculture sector and the urban lower-middle class - it employs no less than 85% of the labor force and accounts for half of the national income. Despite the immense impact of demonetization on the economy, it has barely made a dent in the supply of black money. Of the 14.2 billion rupees circulating as 500 and 1000 rupee notes before demonetization, at least 13 lakh crore rupees had been deposited in banks by the end of the currency exchange period. The 1 lakh crore residual, which represents the now useless black money, is a far cry from the RBI’s estimate of 3-5 lakh crore. Clearly, people find ways to get around the system, as they have often done in the past.

It is possible that demonetization was an important signal that there will be consequences for corruption and black money activity and that the current regime is willing to take a strong stance on these issues. Considering the serious repercussions for the majority of the population, however, the reality is that the currency swap was a dictatorial and inefficient policy that holds little promise for long-term gains. To truly make progress in achieving its alleged goals, the Indian government must push for concrete follow-up reforms.

Reducing Cash-dependence

Instead of forcing people to utilize technology in transactions through demonetization, however, the government needs to incentivize the development of infrastructure and attitudes that will promote the adoption of electronic methods. Thanks to an initiative that provides basic bank accounts linked to mobile numbers and the newly available Aadhaar ID cards, more than 200 million new bank accounts have been opened in the last two years.

Despite this rapidly expanding infrastructure, many accounts remain inactive and at zero balance, implying that there are barriers to usage. While people who use debit cards, e-wallets, and the UPI (Unified Payment Interface) are highly satisfied with their experience, the critical mass of people using and benefitting from cashless modes of payment in the lower and middle classes is simply not enough to convince the larger population to buy-in.

Several reports and studies indicate that there is low awareness of the existence and benefits of debit cards, online banking, and mobile payments among consumers and merchants, which could be a reason for low rates of usage. The general public’s inexperience with technology also leads to mistrust of digital financial services. While farmers’ benefits and pensions are transferred directly into bank accounts, the government needs to invest in awareness campaigns to bridge the gap in supply and demand. Local governments can work with NGOs to run education camps in urban fringes and rural areas, learning from Peru’s example of a network of agents dispersed in low penetration areas. These agents have overwhelmingly increased knowledge and trust in electronic systems, which is crucial to spurring participation.

Surprisingly, research published by the Consultative Group to Assist the Poor (CGAP) on Peru’s agent network indicates that greater financial literacy and trust do not translate directly into increased rates of usage. From a merchant’s  perspective, trialing electronic payment methods is too risky to consider, especially since cash operations are tax-free. However, there is merchant demand for easier access to credit, and both public and private sector banks can market this feature of internet banking to increase uptake.

A direct policy approach would be to subsidize point-of-sale devices that allow transactions via debit card, online banking, and mobile phones for vendors to defray set-up costs. The subsidy should be given to banks that provide these devices along with brief user training and maintenance services in order to ensure security and build long-term opportunities for interaction between banks and their customers.

While supply side changes are vital to facilitating a robust and widespread digital finance system, insufficient consumer demand for electronic payment methods is still a major hindrance. This is largely due to limited options of “cashing in” their earnings, a problem that would essentially be eliminated if employers paid wages and salaries electronically in the first place. Granting tax breaks to businesses that switch to electronic payment is a policy that will demonstrate how electronic methods relieve the larger economic ecosystem of the costs associated with cash transactions. However, as firms’ costs of adjusting to the digital infrastructure dwindle over a given number months, the tax incentive must be tapered off. This policy, however, is geared towards the services industry, and may not cause a shift of payment modes among agriculture and wage labor.

According to an analysis of emerging market countries, published by the Bill and Melinda Gates Foundation, the two key drivers of financial inclusivity are mobile technology and competitive, low-cost digital payment platforms. The Indian government has contributed the Immediate Payment Service (IMPS) and Unified Payment Interface (UPI) platforms, which enable inter-bank transactions through mobile phones and the Internet. This existing infrastructure, in combination with the previously mentioned policy interventions, has the potential to encourage immense growth in cashless transactions across diverse industries and regions of the Indian economy. 

Malvika Govil is a junior from Weiss College. 


Manyika, James, Susan Lund, Marc Singer, Olivia White, and Chris Berry. Digital Finance for All: Powering Inclusive Growth in Emerging Economies. Report. McKinsey Global Institute, 2016.