Behind the scenes: How the Modi government came to its decision to scrap high-value currency notes

On January 31, 2011, a task force set up by the Bharatiya Janata Party to suggest measures to tackle black money submitted a slew of recommendations on how to combat the menace. The party was in the Opposition at the Centre at that time.

Among the 23 recommendations the task force furnished in a 95-page report, demonetising Rs 500 and Rs 1,000 denomination notes did not even figure as a pointer.

However, nearly six years later, as Prime Minister Narendra Modi addressed the nation on November 8, and declared that these currency denominations would be worthless by midnight, it was clear that the government had decided to make demonetising high-value currency notes the focus of its efforts to tackle black money.

Black money bug bear

In its report, the task force, which had several prominent members of society, including current National Security Advisor Ajit Doval, as members, had been specific. It said that domestic black money was not a menace and that the government of India needed to go after money stashed abroad.

The report stated:

“Very often the discussions veer round to domestic black money. Domestic black or unaccounted money is definitely important. At least Domestic black money is used in our economy and to that extent it is productive. But the money kept in Swiss Banks is neither useful to India nor [does] it benefit Indians. Domestic black money is a vote of no confidence on the Government only while illegal Indian wealth abroad is a vote of no confidence on India as a country and hence treason."

Clearly, the BJP task force had drawn a distinction between different kinds of black money – domestic and foreign.

It is now clear that the government’s move to replace Rs 500 denomination notes with new high-security ones, and withdraw Rs 1,000 denomination notes targets only the black money floating around in India, which forms part of the parallel economy, while the bulk of unaccounted money existing in accounts held by Indians in banks abroad remains safe.

So why then did the Union government decide to go ahead with its demonetisation policy on Tuesday?

Action taken

Nearly five months ago, faced with a barrage of criticism from the Opposition that it had not done anything to crack down on black money, the prime minister asked several senior officials to find ways to make a demonstrable and radical move against the menace.

Insiders in the government told Scroll.in that the government felt that it had already taken several steps to curb black money, but this had not evoked the kind of response among the public that it had hoped for.

Two days after Modi took over as prime minister in May 2014, the government set up a Special Investigation Team for black money with Justice MB Shah as its chairman. By December 2014, the team submitted a few observations to the government. The scrapping of high-value notes was not among them.

Similarly, from June to September, the government offered a voluntary disclosure of income scheme, under which Rs 65,250 crores was declared, netting the exchequer approximately Rs 29,000 crores in taxes and penalties.

Demonetisation debate

Discussions on the demonetisation policy were triggered by a suggestion made in 2012 by R Vaidyanathan, a professor at the Indian Institute of Management, Bengaluru, who was also a member of the BJP’s 2011 task force. Vaidyanathan is a votary of scrapping high-value notes as a measure to counter the hoarding of black money, and has written extensively on the subject. Senior government officials frequently consulted him on the issue of black money when the BJP took power at the Centre.

Vaidyanathan’s proposal seemed to find wide acceptance among the key people involved. He held several discussions with National Security Advisor Doval. A few senior officials from the Reserve Bank of India were roped in, and informal discussions began with key bank officials from the public and private sector.

However, the demonetisation policy just announced is different from that envisaged by Vaidyanathan.

The professor is of the view that all high-value notes must be demonetised to ensure that people find it difficult to hoard black money as smaller currency denominations take up more storage space than bigger ones. In addition, lower denomination notes add to the cost of transportation costs since consignments are much larger.

However, though the government agreed to demonetise high-value notes, it inexplicably decided to reintroduce a freshly-designed Rs 500 note and an even higher denomination Rs 2,000 note into the economy. The justification for this was that the new notes would be better designed to prevent counterfeiters from making copies, and would also be issued under controlled circumstances to ensure better tracking by the government.

Combating counterfeit currency

At some stage of the talks, said senior government officials, the focus shifted to “addressing fake currency, rather than curbing black money, even though that [black money] had been the trigger”.

Till last year, fake Indian currency notes had become a major worry for the government, but they were not at alarming levels yet. However, the Intelligence Bureau, India’s internal intelligence agency, noted in several reports this year that Pakistan was injecting fake currency into the country to facilitate terror strikes in Jammu and Kashmir, and weaken India’s financial architecture.

“FICN [Fake Indian Currency Notes] had become a menace and they were only in Rs 500 and Rs 1,000 denominations,” said a senior intelligence official familiar with the issue.

The government's estimates were that nearly 70 crore fake notes were in circulation, as per conservative estimates. Any attempt to track and remove these notes from the market was deemed impossible, said the official. But sudden demonetisation would disrupt this syndicate overnight, officials assumed.

Though there were apprehensions that demonetisation would disrupt the national financial and economic architecture, the government finally decided that the best way forward would be to scrap existing high-value notes and take everyone by surprise.

Subsequent weeks also saw intense discussions on the political impact of such a move. Insiders said that at least two senior party members, who were part of the discussions, argued that demonetisation would seen as a “bold and decisive move”.

This view found favour with Modi, who agreed that it would disrupt circulation of the fake currency network in India significantly.

Part of the planning also leveraged the introduction of the Jan Dhan Yojana Bank account scheme. With larger numbers of people within the formal banking fold, the government was confident they could pull this off.

The finance ministry was tasked to work with the Reserve Bank of India to finalise currency designs that would incorporate security elements to make duplication of the new notes as difficult as possible.

“It was pointed out that eventually people would find a way to duplicate the new notes, but the consensus was that it would be a significant disruption for some time,” said the senior financial intelligence official.

Clearly, worries about fake currency and political considerations drove the final decision, as banks were prepared for the move at the highest levels. Finally, the fact that in 1978, the Morarji Desai government also scrapped high-value notes also helped.