The speed with which the Narendra Modi government pushed through demonetisation has left many commentators fearful of the economy’s future. The consensus among most economists is that the move will lead to a short-term contraction of the economy. The future benefits, however, are unclear.
One of the key features that determine the long-term health of the economy is the level of trust the public has in the country’s economic and financial institutions. Looking at the history of demonetisation efforts, it is evident that where economies have been put through sudden “shock treatments,” long-term economic performance has actually been harmed due to falling trust levels in the government and the financial architecture. The longer the current debacle goes on, the more perilous the prospects appear for long-term performance.
Given the situation, it could be worth looking at how other countries who used the tool of demonetisation fared in the aftermath.
Zimbabwe: Resentment and slowing growth
Racked by hyperinflation, and in an attempt to stabilise its economy, Zimbabwe decided to replace the Zimbabwe dollar with the American dollar in 2015.
The process was carried out hurriedly and this speed hurt wealth-holders, many of whom saw their accumulated savings turn valueless due to the move. Even though the move brought a modicum of monetary stability, it led to resentment among most people, who claimed that the compensation against the loss of their earlier holdings of Zimbabwean dollars was too low.
The decision to shift to the American dollar had another unintended effect: depressing economic growth, as Zimbabwean exports were hit due to a loss of competitiveness.
Myanmar: Loss of trust
The military government resorted to the demonetisation of some denominations of the Myanmarese kyat three times, all to curb black-marketeering and smuggling. The demonetisation drive of 1987 was the most stringent, with no provision for any exchange of the scrapped denominations. New ones were introduced only a few weeks later, too late to quell the severe problems the economy now faced.
Economic theory holds that a reduction in the amount of currency in the economy would lead to a fall in prices. However, demonetisation some kyat denominations in Myanmar had the opposite effect. Farmers refused to sell rice as they did not wish to hold the old currency, and new currency was not available to replace the newly-illegal tender. Those in urban areas began to frantically buy goods, just so they were not forced to hold outlawed denominations of cash. All this led to a severe burst of inflation.
The rise in prices severely affected real wages of the urban section, for whom salaries remained largely fixed. Moreover, the sudden increase in commodity demand led to an increase in smuggling from China which could produce goods at cheaper prices due to higher levels of productivity. Myanmar subsequently underwent a period of economic stagnation, with food prices rising and the domestic industry suffering due to competition from Chinese products.
The resentment that followed this period of protracted economic hardship was a key reason behind the riots and uprisings of August 1988.
These sudden moves had far-reaching repercussions. The public’s loss of faith in the country’s monetary authorities led to large-scale holdings of dollars instead of the domestic currency in Myanmar. This massive dollarisation led to the central bank imposing restrictions—as of 2015—on dollar-based transactions. A strongly negative trade balance, coupled with the public’s preference for dollars, has led to major problems in the sphere of monetary management. A move to introduce high-value notes by the central bank has brought back fears that the government plans another round of demonetisation. The shock move in 1987 led to a loss of faith in domestic institutions and affected domestic policy-making for more than two decades since then.
USSR: A nation split
Prime minister Narendra Modi’s move finds an echo in an unlikely context. On Jan. 22, 1991, president Mikhail Gorbachev of the Soviet Union declared 50-ruble and 100-ruble notes invalid as of midnight that very day. Old notes could be exchanged for new ones only for three days, after which note holders would have to appear before special commissions to get their worthless currency replaced. Extremely restrictive conditions were imposed on the withdrawal of currency, much like what the government has imposed today. The aim, as explicitly stated, was to combat the parallel economy.
It is believed that the economic dislocations this move caused fuelled further events down the line. Several Soviet republics such as Kazakhstan and Ukraine were severely affected by this move. Economic activity took a major hit, meanwhile. People began to lose faith in the government and, historians believe, all this might have led to the eventual break-up of the USSR.
In 1993, the Central Bank of Russia announced that the pre-1993 ruble banknotes would no longer be legal tender, and those republics that agreed to follow the monetary and fiscal policies set by Russia would receive fresh money supply. This led to countries such as Georgia, Azerbaijan, Turkmenistan, and Moldova choosing to leave the ruble zone.
The foundation of a modern economy is trust in its monetary and financial architecture. Moves such as demonetisation jeopardise that trust: the economy is far too complex a mechanism to subject to shock treatment on the scale that the Modi government has envisaged. As events unfold, and the damage to the economy slowly becomes evident, the proposition that long-run growth will be positively affected by the move seems to be one of profound wishful thinking.