Why Modi Just Banned Rs. 500 and Rs. 1,000 Notes


It was sometime in April 1999. The summer was at its peak in Ranchi, the city I was born and brought up in.

I was writing my final year graduation exams in Mathematics. The examination centre was a rather non-descript college, whose name I don’t remember now.

On the first day of examination there were power cuts. The examination centre did not have any power-backup. Thankfully, I had a sort of a premonition of this and was wearing a pyjama-kurta on that day. This is something I can distinctly remember.

Everyone around me was sweating profusely. The sweating was not just because of the power cut. The question paper was totally bizarre. The questions that had been asked had never been asked before.

As anyone who has done his graduation from an Indian university would know, students essentially prepare in two ways. One, is that they look at question papers of previous years and mug up the answers to the questions asked. The other is preparation through guess papers.

Local publishers publish what they think are questions that are likely to be asked in the exam. Typically, these guess papers are ghost written by university professors looking to make some money on the side.

Sometimes, the professor who is writing the guess paper also ends up setting the question paper. And in this case, students who have prepared using the guess paper hit the jackpot.

But sometimes that is not the case. And something similar happened that morning in April 1999. The questions were neither from the guess paper nor had they been asked in the previous years.

It would be safe to say that 90 per cent of my class was caught unprepared. And some of them were totally screwed. As often happens in these cases, the universal opinion after the exam was that the questions were totally out of syllabus.

Something similar, happened on November 8, 2016. When everyone was preparing to discuss the American presidential results, prime minister Narendra Modi dropped a bombshell. The government of India decided to ban Rs. 500 and Rs. 1,000 notes with effect from midnight of November 8, 2016. In question paper terms, this was something which was totally out of the syllabus. No one was expecting it. And the media, as usual, did not come to know about it, until the prime minister started addressing the nation on TV.

The banned notes can be deposited at “bank or post office accounts from 10th November till close of banking hours on 30th December 2016 without any limit”.

At the same time, notes of only up to Rs. 4,000 can be exchanged. This limit will be applicable for the next fifteen days and will be reviewed after that.

What is the logic behind this? As per the government “Fake Indian Currency Notes (FICN) in circulation in these denominations are comparatively larger as compared to those in other denominations.”

The government is planning to introduce new notes of Rs. 500 as well as Rs. 2,000. As it said in a press release: “New Series bank notes of Rs. 500 and Rs. 2,000 denominations will be introduced for circulation from 10th November, 2016. Infusion of Rs. 2,000 bank notes will be monitored and regulated by RBI.”

The question is why is the government doing this? There is an answer based on economic theory. And there is an answer based on politics. I will try and give both the answers here. First, let’s look at the answer based on economic theory.

The move seems to be inspired from the American dollar as well as the British pound. In the United States, the highest denomination bank note is $100. When it comes to the United Kingdom, the highest denomination bank note issued by the Bank of England is £ 50. In the United States as well as the United Kingdom, the highest denomination note is essentially 50 times the smallest denomination note of one dollar or one pound.

In India, up until now the highest denomination note was Rs. 1,000 and this was 1000 times the smallest denomination note of Re 1, issued by the ministry of finance. When a currency has notes of higher denomination, it is easier to launder money i.e. store black money.

To give you an example, with Rs. 1,000 notes in circulation it takes lesser space to store black money in comparison to a situation when the highest denomination note is Rs. 100. At the same time, it also makes it a little more difficult to bribe anybody. Further, if the highest denomination note is Rs. 100, then cash transactions in black will become difficult.

That’s one point. The second point here is that with Rs. 500 and Rs. 1,000 notes being banned, the people who have black money in the form of cash will have to come forward and declare it with the banks. At least, that is the theoretical assumption.

The trouble here is that no one really knows as to how much black money is stored in the form of cash and how much has been stored in the form of physical assets like land, flats, gold etc. Hence, the move is likely to inconvenience those people who have black money in the form of cash. From my conversations with a couple of CAs, I can say that people who have cash, are worried.

Of course, the flip side to this argument is that new higher denomination notes of Rs. 500 and Rs. 2,000 are being introduced. But to get these new notes, those who have black money in the form of cash will have to deposit the banned Rs. 500 and Rs. 1,000 notes in the banking system. And if they do that, this is likely to generate some interesting data for the government. Or they will have to figure out other interesting ways to ensure that their black money in the form of cash continues to hold value.

Also, these new notes are likely to take some time to move through the system and get to a situation where they start being used to hoard black money all over again. So, that I guess was the economic logic behind the government’s decision to ban Rs. 500 and Rs. 1,000 notes.

And what about the political logic? Tackling India’s black money problem has been a pet agenda for the Bhartiya Janata Party as well as Narendra Modi. While, efforts have been made in the past to tackle this problem, the results at best have been mediocre.

By taking the decision to ban Rs. 500 and Rs. 1000 notes, Modi has managed to give a new lease of life to the black money issue. This projects Modi as a strong leader who is willing to take strong decisions which can be unpopular with a certain section of the population. And the electorates just love strong leaders.

The decision goes against the trading community which sits on a lot of the black money in India. At the same time, it is also a major financier of Modi’s Bhartiya Janata Party at the state as well as the local levels.

This decision goes against this community and at the same time projects Modi as a leader who is willing to take decisions even if they go against a section of his supporters. Also, by banning Rs. 500 and Rs. 1,000 notes overnight, Modi did not give those who have black money in the form of cash, to be able to do something about it.

The interesting thing is that this decision has come nearly midway through Modi’s five-year term and at a time when the assembly elections are due in Uttar Pradesh.

The column was originally published in Vivek Kaul’s Diary on November 9, 2016