How Consumers Undermined India’s Currency Overhaul

When India demonetized its currency, officials hoped the abruptness of the policy change would force tax evaders and cash-dependent black-market transactions into the formal economy, where fewer than 7 percent of the population pays income taxes. One November evening in 2016, the prime minister announced in a television address that at midnight all 500- and 1,000-rupee bills—more than 80 percent of the currency in circulation—would become illegal and would need to be deposited into bank accounts or exchanged at banks for newly issued notes.

But a study of transactions at a large Indian retail chain suggests that many consumers, through strategic shopping, undermined the goal of bringing unaccounted money back to the banking system. Their behavior highlights the importance of considering a potential policy’s impact on nontarget groups, write Stanford’s Yewon Kim, Chicago Booth’s Pradeep K. Chintagunta, and Indian Institute of Management Bangalore’s Bhuvanesh Pareek.

Meaningful policy change at the national level can take months or even years to design and implement. India’s demonetization, however, created a situation where a new policy was enacted virtually immediately, and thus had clear effects that researchers could study.

Under the policy, the retired currency could either be deposited in bank accounts within 50 days or be exchanged for new notes over the counter at banks within 16 days, subject to low daily limits. Many banks were quickly overrun.

But many people wanting to exchange currency also headed to stores, the research suggests. Using daily store-level transaction data from a large retail chain dealing in nonperishable, high-ticket items, the researchers studied more than 7 million transactions spanning 14 months before the policy took effect through 13 months afterward. The data included invoice date, price paid, payment method, and number of items sold, and also indicated whether a transaction was a return or a purchase. The analysis included stores in 27 districts in India with a wide range of demographics.

The researchers find that shoppers managed to avoid depositing cash in formal bank accounts by spending the soon-to-be illegal notes and in many cases returning their purchases in order to obtain legal notes from the retailer. The night the policy was announced, many consumers bought high-priced items in what the researchers call “strategic purchases.”

Unintended effect

“On the day the announcement was made, there was this huge bunching going on,” Chintagunta says. By buying pricey items such as appliances, consumers avoided the costs associated with exchanging expiring notes at banks.

Some people kept their purchases, which they might have otherwise made later. But others, through “strategic returns,” swapped the cash-purchased items for the new currency, thus avoiding bank-related exchange costs. Among purchases made in the hours after the announcement that were later returned, nearly 80 percent were made with cash. This suggests consumers were motivated to use banned notes to buy goods and later receive legal notes for the returns, as only cash sales could be refunded with cash under the chain’s policy, the researchers note.

For consumers, the policy change proved largely inconvenient. Media coverage showed people waiting in long lines at banks so they could buy food and other necessities. Those who avoided banks nonetheless suffered due to the additional steps they had to go through to convert their currencies to the new one. “The objective—transparency—was a good one,” Chintagunta says. “In reality, it caused a lot of hardship for people who really did not have any ill intentions and were not doing things illegally.”

For policy makers, the move was largely a disappointment. Within six months of the announcement, nearly 99 percent of the old notes were returned to the Indian banking system without any significant short-term increase in the number of taxpayers or direct tax revenues, calling into question the policy’s effectiveness.

“Our analysis suggests that strategic consumers hindered the intended policy effect while partly benefiting the retail chain,” write Kim, Chintagunta, and Pareek. This left 20 million rupees (US$300,000) of demonetized notes outside the formal tax network through this one retail chain. Scaling up the amount falling through the cracks on the basis of India’s market size increases the estimate to 100 billion rupees, or around 20 percent of that year’s budget of Delhi, the researchers calculate.

The retailer enjoyed some extra sales, although not as many as it would have had it known of the policy beforehand. With time to stock up on supplies and launch advertising campaigns, the retailer could have seen an even larger spillover effect, suggest the researchers.

The researchers say they hope understanding the microlevel consequences of macrolevel government intervention will help lawmakers better craft monetary reforms to stem illicit financial flows—and perhaps transition to a cashless society, as many governments are now pondering whether and how to do.

Kim says that while the research contains lessons for countries considering making financial reforms, the implications can go further: “We hope this can open more rich discussions about unintended consequences of other macroeconomic or market-level policies.”

More from Chicago Booth Review

Related Topics

More from Chicago Booth

Related Topics

Your Privacy
We want to demonstrate our commitment to your privacy. Please review Chicago Booth's privacy notice, which provides information explaining how and why we collect particular information when you visit our website.