What is Demonetization?

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Definition:

Demonetization is an economic intervention that strips a country’s currency unit of its legal tender status – aka it can no longer be used to buy goods and services.

🤔 Understanding demonetization

Demonetization most often occurs when a nation replaces its currency, in whole or in part, with a new form of money. A government may replace the discontinued currency with either new notes or coins of the same type, or a new currency altogether. Demonetization is a rare, dramatic, and often disruptive action. Governments may do this when they lose control of their currency due to things like hyperinflation, tax evasion, and counterfeit currency. Sometimes, demonetization must happen so that a new standard of payment can become the primary currency. After the European Union formed, for example, a new currency – the euro – was adopted across participating countries. Several nations demonetized their former currency as the euro became the new norm. Lastly, countries may use demonetization to promote a cashless economy.

Example

In the early 2000s, the government of Zimbabwe lost control of its currency due to hyperinflation (i.e. the extreme increase in the price of goods and services, and resultant reduction of a currency’s purchasing power). At one point, the inflation rate hit an astronomical 500 billion percent.

The Zimbabwean dollar became so worthless due to this hyperinflation that the country began printing bills worth 100 trillion Zimbabwean dollars apiece. By 2015, most businesses stopped accepting the currency altogether. Instead, they demanded other global currencies, such as euros and US dollars, for forms of payment.

The government eventually stepped in and retired – aka demonetized – the old fiat money. During the demonetization period, which lasted three months, people could trade in 175 quadrillion Zimbabwean dollars for a single US $5 bill.

Takeaway

Demonetization is like if your local stores only started accepting cryptocurrency…

In our current day, many people use cash to pay for goods and services. But as cryptocurrencies gain popularity, let’s say we fast forward several years and we all start using cryptocurrency instead of paper money. Fewer and fewer businesses accept cash and fewer and fewer people use it. This hypothetical process of switching from paper money to cryptocurrency is demonetization. Paper money would go out of circulation. Though you might still find a few bills or coins being kept for sentimental reasons.

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What is the purpose of demonetization?

Typically, a country only uses one currency as its legal tender. In the modern era, every country on the foreign exchange market uses fiat money, which simply is currency that has value because it is issued by a country’s government. These currencies have exchange rates that tell you what one type of money is worth relative to another – for example, how much one US dollar is worth compared to the euro.

Having a stable and well-established form of payment is required for an economy to run efficiently. Without a constant measure of trade, the economy would revert to a barter system and chaos would likely ensue. It would certainly make it more difficult for countries to trade and interact on a global scale.

The purpose of demonetization by a country’s government is to get an old, ineffective currency out of circulation. Demonetization occurs when a country’s government declares that a currency no longer has value. It will stop further issuance of some or all of the money it prints. The authorities then typically replace the demonetized currency with either new types of coins or notes of the same currency, or a new currency altogether. The government typically provides its citizens with a set period of time to exchange the demonetized money for these newly accepted forms of currency.

A government may opt to do this for a number of reasons, such as when they lose faith in the underlying value of the currency, citizens don’t trust the worth of the money, or some political change requires the type of money to change. Breaking this down a bit more, demonetization measures may be taken due to events like hyperinflation or other monetary devaluation, the increased circulation of counterfeit currency, tax evasion by individuals and businesses, or the creation of economic and political unions.

There are historical examples of each. For example, Zimbabwe finalized the demonetization of its dollar in 2015 due to hyperinflation. Two key reasons that India demonetized its large rupee notes in 2016 were concerns over tax evasion and an increase in circulated counterfeit currency. Finally, when some countries left the former Union of Soviet Social Republics (USSR) many years ago, they demonetized the ruble in favor of novel currencies for their new nations, such as Turkmenistan adopting the manat.

A government may also demonetize certain types of currency to promote a cashless economy. If a nation conducts the majority of its business in cash and the government believes it would be beneficial to move to cashless transactions, such as via debit and credit cards, it may decide to pursue some form of demonetization.

What is the demonetization process?

The formal process of demonetization occurs when the government declares the end of a form of currency, whether in whole or in part. Once demonetization is complete, the old notes or coins completely lose their value. Merchants are no longer required to and will not accept that old money as payment for goods and services. Often, the retired currency will be replaced with either new notes or coins of the same currency or a new currency altogether.

Imagine having worked hard to prepare for retirement, and then one day learning that all of your savings are now worth nothing. For this reason, the government usually provides a transition period so that people can convert the cash they have into currencies that are still or newly considered legal tender.

Businesses will likely immediately stop accepting the demonetized currency, but banks may allow you to trade that old currency into some other form of legally recognized money at a set exchange rate. For example, Zimbabwe gave everyone three months to swap their old Zimbabwean dollars for US dollars. After this alloted transition period, banks no longer honored a trade of this demonetized currency.

Following transition periods, the old paper and coins become souvenirs of the past. They might still have value to a collector, but your local store won’t accept them as payment anymore and you can’t exchange them at the bank.

What are the effects of demonetization?

Demonetization is usually a painful process. The cash in your pocket or home can suddenly become worthless. But it may be necessary to keep an economy afloat. Like many things, the process has advantages and disadvantages.

Advantages

Demonetization can allow the government to regain control over its currency. If a specific type of bill is being counterfeited, the government can demonetize that bill and replace it with another kind that is more difficult to copy – this immediately invalidates all of those counterfeit bills in circulation since businesses will no longer accept them regardless. So, one advantage of demonetization is that it can reduce counterfeiting.

Another advantage for a central bank that has lost control of its currency is that this demonetization process can help to stabilize it. For example, if hyperinflation (i.e. the extreme reduction in the purchasing power of a currency) occurs because the government has printed too much money, demonetization can remove the root cause of the problem. By switching to a currency that hasn’t been minted in excessive amounts, runaway inflation can be stopped.

In theory, a country could also demonetize its currency to encourage fewer cash transactions. The advantage of this is an increase in the digital record of payments. This switch may be advantageous if a lot of economic activity is happening under the table. Following demonetization in this situation, the government may gain more control over taxation. This can be particularly advantageous in countries that suffer from tax evasion and lose out on tax revenue. More efficient taxation could lead to that government’s ability to spend on public good initiatives, such as transportation infrastructure and education.

Disadvantages

The downside of demonetization is that it is always disruptive. At a minimum, the change forces people to do something inconvenient like stand in a long line at the bank. At worst, a sudden and unexpected change to the country’s currency can create chaos in the economy.

When money is demonetized, businesses stop accepting that cash as a legal form of payment. For individually owned and small businesses that operate primarily using cash, that also means they likely now have no valid money to pay employees or vendors. Without compensation, employees might not show up to work. And, without customers, very little business can be done – livelihoods may be threatened if the business has to close.

While the population scrambles to secure the new notes, the economy in the interim can become unstable until the new legal tender finds its way into the market and the public adjusts.

What is happening with demonetization in India?

To date, the demonetization effort in India is the most recent example of this process, and it made headlines around the world. On November 8, 2016, the Indian prime minister Narendra Modi announced to the world that its 500 and 1,000 rupee notes were worthless effective immediately.

With little notice, Modi announced that the Reserve Bank of India would be rolling out new banknotes that were thicker, larger, and more challenging to copy. Anyone who had the demonetized bills could exchange them at a bank during a transition period of 5 months, but merchants stopped accepting them as payment immediately.

What ensued was a period of chaos for the Indian economy. The vast majority of trade in India prior to the announcement happened as cash transactions. And those two demonetized banknotes represented 87% of all cash in circulation at the time. Pulling these out of circulation created an immediate cash shortage.

However, the government knew that many of those bills were counterfeit. If the fraud money was presented to a bank, it would be seized and destroyed. The Indian government also knew that a lot of the cash transactions were happening in the informal economy and taxes weren’t being paid on these earnings – aka black money.

By forcing people to bring large sums of money to a bank, they could ask for proof of how that person received the cash. If there was no evidence that the cash was received from a legitimate transaction involving a tax payment, the government took a cut of the money to compensate for the unpaid taxes. One of the other stated reasons for the demonetization of the large bills was that it would encourage a move away from cash payments toward digital transactions.

Unfortunately, India has a large percentage of the population without bank accounts, credit cards, or payment apps. Its economy is still quite cash dependent, and pulling cash out of circulation did not suddenly create a seamless digital economy.

In fact, as a result, economic activity slowed down a lot. When most of the money that is circulating is suddenly worthless, it is hard to conduct business. While this measure probably upended the underground economy, it also halted legal business activity around the country. By one researcher’s estimate, the action caused a two percent reduction in India’s unofficial gross domestic product (GDP).

People spent their days waiting in line to trade out the worthless paper in their pockets instead of infusing that money into the economy by spending on goods and services. With few funds flowing, business dried up. Many small businesses closed their doors, and an economic slowdown ensued.

Was India’s demonitization the right move?

The jury is still out on whether India's demonetization effort was worth the economic disruption. Some critics suggest that, because very little counterfeit currency was captured, the policy goal was not achieved. At the same time, people with counterfeit bills now had worthless notes in their pockets.

Other critics point out that the detrimental effects were not worth the gains. The loss of economic output and disruption to people’s lives are costs that shouldn’t be discounted.

Also, critics state that those most impacted were people most reliant on cash and least likely to have bank accounts. Among them were impoverished urbanites and rural farmers who couldn’t purchase the materials they needed to eke out a meager living.

Therefore, critics note that the distributional effects were inequitable. The gains mostly helped the upper class, while the losses were felt mainly by the poor.

However, supporters claim that demonetization successfully reduced counterfeiting, money laundering, tax evasion, and the financial support of terrorism. They say that post demonetization, legitimate economic growth is more robust than it would have been otherwise.

Proponents suggest that the banking system today is stronger and the effort to move toward a cashless economy was successful. They point to lower inflation, higher stock market values, increased lending activity, improving GDP growth, and an acceleration of digital payments as evidence that the effort was successful.

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