Michael Jackson was fairly prescient about India’s current demonetisation woes when he released Dangerous in 1991. With tracks such as Black or White, In the Closet, Give in to Me, Gone Too Soon and Dangerous, it was one of the best-selling albums of all time. His next album was titled HIStory, and perhaps one can learn something from that as well.

The demonetisation of high-denomination bank notes has occurred three times at the all-India level in the past 70 years – in 1946, 1978 and 2016. All three policy decisions were well-kept secrets and involved the sudden withdrawal of high-value currency notes with immediate effect. Bank holidays after the announcement and declaration forms at banks were standard operating processes in all three episodes. In terms of stated objectives, the events targeted black money (1946), illegal transactions (1978) and fake notes and black money (2016). They differed substantially, however, in terms of scale as the invalidated notes comprised around 10%, 1% and 86% of the total currency in circulation, and consequently in the time period given for the currency exchange at the initial stage – 10 days, three days and 50 days, respectively.

Remarkably, they all failed to extinguish black money held in cash, which is measured as the share of invalidated notes not returned to the banking system. Only 7% was unreturned in 1946, 15% in 1978 and, judging by recent news reports, the figure is estimated to be less than 15% in 2016. The gain through tax raids and amnesty schemes in the current round will have to be squared against the serious disruptive costs that were not incurred in previous rounds. These costs are also disproportionately borne by the informal sector and, in particular, by daily-wagers.

If most of the invalidated notes return to the banking system, sudden demonetisation does not provide a superior alternative to gradual demonetisation where legal tender is invalidated at a future date. All the other expected gains from the current effort – countering fake notes, promoting cashless transactions and deepening the financial system – are equally plausible under gradual demonetisation with reasonable withdrawal caps. The only argument against gradual demonetisation is that it may be inflationary, as people may rush to buy goods and assets during the transition period. While not sharing the same objective as the current policy, the gradual demonetisation of the entire currency in circulation in Hyderabad state in the 1950s, as part of its financial integration with the Indian Union, provides a useful case to understand this phenomenon in the Indian context.

No Hyderabad blues

A 10 Hyderabadi rupee bank note. Photo credit: Wikimedia Commons

By 1948, Hyderabad state, covering districts in modern Telangana, Maharashtra and Karnataka, was the only major princely state to have its own legal tender – the Hali or Osmania Sicca. The currency was used by nearly 20 million people spread over 20,000 villages and towns, mainly as coins but also as paper notes of varying denominations. An exchange rate of roughly 116 Hali Sicca rupees to 100 British Indian rupees had lasted for nearly a century under the Asif Jahi Nizam rule with only minor fluctuations. Counterfeits were not unknown as sensational cases of coin forgeries and theft of high-denomination Hyderabadi currency notes printed by Waterlow & Sons in England often created newspaper headlines.

The Hyderabadi currency was demonetised in three phases. First, Indian currency became legal tender in Hyderabad state from January 26, 1950, alongside Hyderabadi currency. By January 1953, 50% of the Hyderabadi currency had been withdrawn from circulation without any formal announcement of demonetisation as banks had converted their accounts into Indian currency and were issuing more of this than Hyderabadi currency.

The second step of the demonetisation process came with an announcement in March 1953 that the legal tender of the Hyderabadi currency would expire two years later on April 1, 1955. The gradual nature of demonetisation was justified as a considerable part of the Hyderabadi currency was still in circulation and to avoid “hardship that would be caused to the people by sudden withdrawal of the currency” (Times of India, March 29, 1953). Three weeks after this announcement, it was noted that there had been “no rise in prices as a result of demonetisation” and that 5% of the outstanding currency had been exchanged. There was, however, pressure from union leaders to conduct strikes seeking parity in wages in Indian currency, effectively demanding a 16% hike in pay. Over the next two years, these concerns were placated through various means and by the establishment of industry-wise wage boards. Separately, hoarders of coins were warned and profiteers punished under the slogan One People, One Country, One Currency. By April 1955, over 85% of the outstanding currency had been exchanged. A slight rise in prices was noted in that month due to a recalibration of Hali rupee prices to the higher-valued Indian rupee prices for certain goods.

After cancelling legal tender, the third step involved further extensions to the exchange period, on public request, till June 30, 1959. The only serious disruption and uncertainty in this entire episode was faced by the Hyderabad Mint, which eventually found itself a new role on the minting map of India.

Other gradual demonetisation exercises in India carried out in some of the smaller princely states and for the escudo in Goa, Daman and Diu (invalidated on May 15, 1962) also appear to share similar experiences of negligible economic disruption.

Slow wins the race

The demonetisation efforts of 1946, 1953, 1978 and 2016 suggest that sudden demonetisation is a weak instrument to extinguish black money held in cash and can have high disruptive costs, whereas gradual demonetisation need not be inflationary or disruptive. Interestingly, the Reserve Bank of India History volumes observe that the central bank’s governors – CD Deshmukh and IG Patel – who presided over sudden demonetisation policies in 1946 and 1978 were skeptical about their purpose and benefits. The 1946 operation was a “fiscal measure taken against the Bank’s advice”. And Patel regretted that he had to concede to the demands of the finance minister, HM Patel, in 1978, saying that “the gesture had to be made, and produced much work and little gain”. As finance minister in the early 1950s, Deshmukh had also presided over the gradual demonetisation in Hyderabad, repeatedly assuring the public that no disruption would be caused by the measure. In the future, the Reserve Bank should reflect on its own past and consider gradual demonetisation. It can begin with the newly-introduced Rs 2,000 note and listen to three of Michael Jackson’s tracks when it does so – Remember the Time, Keep the Faith and Heal the World.

The writer is faculty member of the Indian Institute of Management, Ahmedabad, with research and teaching interests in business and economic history and urban economics