Demonetisation

Indian Economy glossary

Topic: Banking, Credit Creation and Monetary Policy · NCERT: Class 10, Ch 3 "Money and Credit"; Class 12, Ch 3 "Money and Banking"

Meaning

Demonetisation means taking away the legal tender status of currency notes. Legal tender is money that people must legally accept when someone uses it to pay a debt. After demonetisation, the old notes are no longer money, and people can only deposit or exchange them at banks for a limited time.

It matters because it is one of the biggest currency shocks an economy can face. In November 2016, about 86% of India's currency in circulation lost its value as money overnight. This hit cash-based trade and flooded banks with deposits. The RBI then had to find new ways to manage liquidity (the spare cash banks hold with the RBI).

Explanation

How it works: from cash to bank deposits

  • Step 1: notes lose legal tender status.
  • Old notes can no longer be used to buy things or pay debts.

  • People must deposit them in banks or exchange them within a set window.

  • Step 2: deposits jump.

  • Cash held by the public turns into bank deposits.

  • So banks' NDTL (Net Demand and Time Liabilities, which is mainly deposits) rises sharply.

  • Step 3: banks have surplus cash.

  • Banks suddenly hold huge funds, but there are few new borrowers.

  • The extra cash goes to the RBI, and the system ends up with a large liquidity surplus.

  • Step 4: remonetisation.

  • Remonetisation means putting new notes back into circulation.
  • In India it went on through 2017.

Why it becomes a liquidity problem for the RBI

  • Too much spare cash pulls short-term interest rates down.
  • Banks have more money than they can lend.
  • Overnight rates fall below the RBI's policy rate.

  • As a result, the RBI loses control over the interest rates it is trying to set.

  • So the RBI must absorb the surplus. Its tools:

  • Reverse repo (the RBI borrows surplus cash from banks for a short time). This works for day-to-day swings.
  • ICRR (Incremental Cash Reserve Ratio): a temporary extra CRR that applies only to the increase in NDTL during a chosen period.

  • MSS (Market Stabilisation Scheme): the Government issues T-bills and bonds, and the money raised is kept aside and not spent.

  • Rule of thumb: a short-term surplus is handled through the LAF (the RBI's daily window for lending to and borrowing from banks). A large, lasting surplus like the one in 2016 needs durable tools such as the ICRR and the MSS.

Worked example: scale and return of notes (2016)

  • Old notes demonetised: ₹15.41 lakh crore (about 86% of currency).
  • Share that came back to banks: about 99.3%.
  • Notes returned ≈ 15.41 × 0.993 ≈ ₹15.30 lakh crore.
  • Notes not returned ≈ 15.41 − 15.30 ≈ ₹0.11 lakh crore (about ₹11,000 crore, which is less than 1%).
  • What this shows: almost all the cash came back. Very little "black money held as cash" was destroyed.

Worked example: how a 100% ICRR drains cash

  • A bank's NDTL rose by ₹1,000 crore between 16 September and 11 November 2016.
  • Under a 100% ICRR, it must park the whole ₹1,000 crore with the RBI, and the RBI pays no interest on it.
  • For comparison, under a 10% ICRR it would park only ₹100 crore.
  • The ICRR does not apply to deposits the bank had before the window.

In India

  • Institutions: the Government of India and the RBI. The RBI is the currency authority, and it manages the liquidity that follows a currency shock.
  • November 2016 episode:
  • ₹15.41 lakh crore of old ₹500 and ₹1,000 notes lost legal tender status. This was about 86% of currency in circulation.

  • About 99.3% came back into banks.

  • How the RBI absorbed the cash flood (2016):

  • Daily reverse repo operations absorbed surplus funds.
  • 100% ICRR applied to NDTL added between 16 September and 11 November 2016. It was imposed on 26 November 2016.
    • It drained about ₹4,000 billion (₹4 lakh crore) in the fortnight ended 9 December 2016 [3].
    • It was withdrawn from the fortnight beginning 10 December 2016 [3].
  • MSS ceiling raised to ₹6 lakh crore. Once MSS bills were available, the RBI released the cash locked up under the ICRR.

  • The MSS itself is based on a 2004 MoU between the Government of India and the RBI. The ceiling is agreed between them from time to time [2].

  • Views in official documents:

  • NCERT Class 12, Box 3.2 lists the benefits: savings moved into the formal system, banks got more resources, lending rates fell and tax compliance improved.

  • The Economic Survey 2016-17 noted the costs: a cash crunch and losses in the informal (cash-based) sector.

  • Later case: May 2023. The ₹2,000 note was withdrawn from circulation but stayed legal tender. The RBI applied a 10% ICRR on NDTL added between 19 May and 28 July 2023 and unwound it by October 2023.

Don't confuse with

  • Currency withdrawal (₹2,000 note, 2023): the notes were taken out of circulation, but they remained legal tender. In demonetisation (2016), the notes lost legal tender status.
  • Remonetisation: this is the opposite process. The RBI puts new notes back into circulation, which in India went on through 2017.
  • Sterilisation: this protects the money supply from external shocks such as forex inflows, using OMO sales or the MSS. Demonetisation was a domestic currency shock, though the RBI used some of the same tools (MSS, ICRR) to absorb the surplus.
  • CRR vs ICRR: the CRR applies to a bank's whole NDTL. The ICRR applies only to the increase in NDTL over a chosen period, and it is temporary.

Prelims Hooks

  • Demonetisation = withdrawal of legal tender status. In November 2016, ₹15.41 lakh crore of old ₹500 and ₹1,000 notes (about 86% of currency) were demonetised, and about 99.3% came back to banks.
  • 100% ICRR (2016) applied to NDTL added between 16 September and 11 November 2016. It drained about ₹4 lakh crore in the fortnight ended 9 December 2016 and was withdrawn from 10 December 2016 [3].
  • The MSS ceiling was raised to ₹6 lakh crore after demonetisation. MSS securities are issued by the Government, not the RBI, and the money raised is not spent [2].
  • Trap: the ₹2,000 note withdrawal in May 2023 was not demonetisation, because the notes stayed legal tender. It came with a 10% ICRR, not 100%.
  • Direction of the shock: demonetisation caused a liquidity surplus in banks, not a shortage, because returned notes became deposits. So the RBI absorbed liquidity.

Mains Points

  • Demonetisation trade-off (GS-III):
  • Gains: more formal saving, a larger tax base, more resources for banks, lower lending rates and a push to digital payments (NCERT Class 12, Box 3.2).
  • Costs: a cash crunch, losses in the informal sector and lost output (Economic Survey 2016-17).

  • Verdict: about 99.3% of the notes came back, which weakens the claim that it would destroy black money held as cash.

  • Lesson for liquidity management:

  • In 2016 the RBI used a 100% ICRR as a quick fix. It drained about ₹4 lakh crore in one fortnight [3], and the ICRR stayed in place until the MSS ceiling was raised to ₹6 lakh crore.

  • Policy lesson: ready, pre-agreed tools that can be scaled up (such as the SDF and the MSS) are better than emergency stop-gaps.

  • Cost of absorbing surplus cash:

  • MSS interest is paid from the Union Budget, so absorbing liquidity has a fiscal cost.
  • The ICRR pays banks no interest, so it squeezes their earnings.
  • So any large currency shock creates a policy choice about who bears the cost: the government or the banks.

Related concepts

Read more

Sources

  1. 1Class 10, Ch 3 "Money and Credit"; Class 12, Ch 3 "Money and Banking" (primary)
  2. 2RBI Press Release, Market Stabilisation Scheme (18 January 2008)rbidocs.rbi.org.in · tier 1
  3. 3RBI, Macroeconomic Impact of Demonetisation – A Preliminary Assessmentrbidocs.rbi.org.in · tier 1