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India: How Consumers Outsmarted the Demonetisation

Categories : Cash ensures competition among payment instruments, Cash facilitates budgetary control, Cash is a public good, Cash protects privacy and anonymity
May 16, 2023
Tags : Demonetisation, India, Regulation, Tax avoidance
Using transaction data from a large retailer, researchers found that Indian consumers increased their cash purchases after the demonetisation of cash in circulation in November 2016.
Guillaume Lepecq

Chair, CashEssentials

This post is also available in: Spanish

On November 8, 2016, India’s Prime Minister Narendra Modi announced that all 500 and 1,000 rupee notes –  86% of the cash value in circulation – would lose legal tender at midnight. This sudden move led the economy to a complete standstill as people spent days lining up at banks and ATMs, scrambling to exchange their old “worthless” notes and deposit them in a bank account.

The policy’s primary objectives were to target unaccounted money and bring it into the formal economy and counterfeit notes. However, the Reserve Bank of India reported in its 2016-2017 annual report that 98.8% of the worthless notes were diligently returned to the bank, placing a serious question mark over the efficacy of the demonetisation to clear unaccounted money.

Using transaction-level data from a large retail chain selling oversized ticket items, the authors of the report – Yewon Kim, Stanford Graduate School for Business; Pradeep Chintagujta, University of Chicago Booth School of Business and Bhavesh Pareek, Indian Institute of Management Bangalore – empirically document how households as consumers avoided or minimised policy-induced costs via strategic transactions at retail stores.

The researchers analysed over 7 million transactions before and after demonetisation. They observed that, following the demonetisation announcement, many consumers made “strategic returns,” buying items with soon-to-be discontinued banknotes to return them in exchange for new notes. This allowed them to exchange their banknotes without visiting a bank, where they would have been required to prove they had paid income tax over a certain amount. Some of the retailer’s stores saw returns increase by nearly 300% in the days following demonetisation.

The researchers also found that shoppers bought items they wouldn’t usually have purchased. Some stores had a 40% sales bump on the day demonetisation was announced. Other consumers made planned purchases earlier or switched their payment to cash to spend their 500- and 1,000-rupee notes.

They extrapolated their estimates to the entire retail market. Using conservative methods, they concluded that Indian consumers had managed to shield an estimated $1.5 billion from the tax system by using retail transactions to their advantage. In the end, the retail chain came out ahead, too. The benefits of the surge in sales outweighed the costs of processing the returns and exchanging old currency for new.

“In the context of demonetization in India, such strategic consumer behaviors resulted in a significant impact that ran counter to the policy aim while benefiting both households the retail chain. Our finding underscores the importance of careful policy design that incorporates the possibility of unintended consequences due to the behavior of consumers at the retail level. We observe that, under the currency reform, retailers (partly) take on the function of financial institutions by accepting soon-to-be demonetized bills as well as distributing legal notes in their local economies.” conclude the authors.

This post is also available in: Spanish