Tuesday, September 5, 2017

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January 2002, people were given fixed windows of time to redeem existing national banknotes before their money status was revoked.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.


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. 


  1. Nice post.

    Some of us were actually predicting that all the bank notes would come back.

    Also, there's one more thing. Because in a short time, people returned so many notes in exchange for deposits at their bank and the the whole thing was poorly planned, this created a huge amount of bank reserves at the Reserve Bank of India. To keep interest rates from falling, the RBI had to lot a lot of reverse repos to soak the excess reserves. The government of India also issued bills and bonds for this purpose.

    This led to halving of the dividend the RBI paid the government last year. So it was a loss making operation, overall.

    1. Hi Ramanan, thanks.

      "Some of us were actually predicting that all the bank notes would come back."

      Good prediction! Not me.

      "This led to halving of the dividend the RBI paid the government last year."

      Good point. There's also the fact that printing costs doubled to Rs 7,965 crore in 2016-17 (US$1.2 billion) from Rs 3,421 crore the year before.

      Although I wouldn't declare it a loss-making operation until we see how much they can groom from the incoming deposits.

  2. Can't help but wonder what the collectors value of the outstanding notes will eventually be.

    1. I'm not sure, but I've been meaning to add one to my collection.

  3. Frankly, the concept that government acquires a windfall when notes are NOT turned in seems inverse to economic reality.

    Here is why that might be true:

    When government prints currency, it gains seigniorage which is (effectively) a sovereign privilege tax. This occurs because government trades fancy paper for valuable labor and resources. The effort expended by government to make the paper fancy is minuscule compared to the value exchanged.

    Once currency in in the hands of the public, it becomes a store-of-value. Each public holder of currency has traded labor or resources for currency and now has (in hand) a physical record of value exchanged.

    Thus, we see that the loser in this India currency cancellation is the public who lost a record of work performed. We can only hope that the loss was widely spread, not bearing too hard on any individuals.

    We also see that there was no gain to the government by cancelling currency. Government got it's privilege tax at the time of printing. Cancelling currency only hurts the public.

    1. Are you saying that governments that demonetize notes *do not* receive windfalls or that they *should not* receive windfalls?

      It's uncontroversial that they *do* receive a windfall from demonetizatons. For instance the Bank of Italy transferred €600 million to the Treasury in 2011 to account for unreturned notes:


    2. Governments do not receive windfalls when governments cancel one currency and exchange it for another. After all, the un-returned notes never reappear physically to be used to pay future expenses of government should government decide to reverse the withdrawal decision.

      No, what happens is the the Bank of Italy (in your example) made the profit claim that, because €600 million had "disappeared", the Italian government no longer had the ability to repay that amount to the Bank of Italy, as government had promised to do. Hence, the Bank of Italy should reissue currency (in the form of bank profits) in the equivalent amount to the Treasury without the Treasury issuing new bonds. The Bank of Italy simply printed new money to replace the not-returned-currency and gave it to the Treasury.

      Yes, we could consider the cancellation of currency (to the extent it is not replaced) as a tax but it is a tax never received by government. As a virtual tax never collected, there is nothing to transfer to use for later payments. However, a window has been opened that can be used by the central bank to print more money for government use.

      Kind of surprising how central bank deception can twist our economic thinking.

    3. "No, what happens is the the Bank of Italy (in your example) made the profit claim that, because €600 million had "disappeared", the Italian government ... simply printed new money to replace the not-returned-currency and gave it to the Treasury."

      Sorry Roger, I'm really not following you.

  4. Well, if we allow that governments can generate fiat seigniorage at the time of initial money creation, then we are allowing government to trade worthless paper for real value. Most economist agree that this occurs in a fiat money situation.

    Now the people who receive that initial fiat money certainly feel that they earn it. Thus, the secondary holders of new fiat money (government is the first holder) will all agree that the money they hold is worth a tangible amount. This fact goes a long way towards explaining why fiat money remains in circulation for long periods of time, and results in about 99% recovery when government (under unusual circumstances) recalls a currency issue.

    Now if government traded fiat money for first value, having expended very little effort to create the money product, why should we later (when government recalls this product) assume that government makes a windfall? If we make such a claim, we seem to be claiming that government profits when fiat money is created and profits again when fiat money is recalled. Two profits from the single act of creating fiat money?

    I don't think so. It is much more logically consistent to assume that government gets it's initial creation seigniorage advantage as commonly understood. Then, later when government decides to recall-and-replace a currency issue, government makes a simple product exchange of new for old.

    The fact that some old currency has been lost (learned only by recall) only reflects that the public has lost some value due to misfortune of some kind. This loss is not cause by government recall, but by physical currency destruction.

    I lost $40 once due to hasty Christmas-wrapping disposal. That was my loss, not the governments. The fact that the Fed may someday replace that money and give it to Treasury in no way is a profit to government. At best, it is a recovery of lost property transferred to government ownership, no different from what occurs when the original owner of a bank account becomes unreachable (The way stale accounts are processed in Washington State).

    This is a different way of thinking about money. The key remains the initial assumption about seigniorage.

    1. "Two profits from the single act of creating fiat money?"

      Why not?

      Walmart issues coupons to its customers. As long as the coupons remain outstanding, Walmart enjoys seigniorage revenues on the float (i.e it earns interest on the funds but doesn't pay interest). Only 99% of the coupon issue is returned before the expiry date. Now Walmart can recognize an additional one-time profit because 1% of its coupons will never be redeemed,--it gets to keep the funds its customers effectively left on deposit.

      Indian rupees are just like Walmart coupons.

    2. I think the coupons are often known as Walmart gift certificates. It is as you say when gift certificates are not redeemed.

      And if Walmart pays employees in gift certificates, forsaking money?

    3. Ah yes, slip of the tongue. I meant gift certificates, not coupons.

      If it pays employees with gift certificates, there's no difference. It buys labour, converts labour into sales, and invests the proceeds into government bonds. Which provides Walmart with seigniorage since it pays no interest on the outstanding issue of gift certificates while earning risk free income on the bonds. When the gift certificates expire, and 1% of them don't come in for redemption, Walmart gets to enjoy a one-time boost to profits.

    4. I was thinking that, should Walmart pay employees with gift certificates, Walmart would have only a claim on store merchandise. It would book the claim as an obligation outstanding.

      This claim-outstanding would disappear when the certificate expired unused, which would be a gain for Walmart.

      Thanks for the lively, informative, and thoughtful discussion.

    5. Walmart issues gift certificates to minimize inventory flow and it needs to offer both deposits and loans. Its interest gains on those rates should vary about zero. With both deposits and loans working, Walmart gets a warning of inventory volatility when loans to deposits change. For example, if Walmart has a riot over towels, raise the deposit rate and some of the brawlers will defer their towel purchase util later.

      In other words, there is no treason Walmart cannot run their own currency lust like the dollar with a complete money market.

  5. Alan Greenspan, Federal Reserve Chairman, 1997


    "[A] government cannot become insolvent with respect to obligations in its own currency. A fiat money system, like the ones we have today, can produce such claims without limit."

    1. A government can easily choose to be insolvent or solvent. They have tax cops and printing presses. Alan spewed a tautology.

      So, the question is, will extreme government measures to remain solvent work better than extreme government measures to default. Alan does not have the facts to determine he better option. We always assume printing press is mightier than the bond fire but that is not how we generally work things. In the past we have chosen to default on our obligations. twice on gold and more than one on government obligations in our history.