What Happens When a Country Goes Through Demonetization?
A government may demonetize a certain denomination of coins or banknotes to reform their national currency. By outlawing a high denomination, they try to fix monetary problems, like the widespread dissemination of a counterfeit currency note, a history of corporate tax evasion, or a burgeoning black money market economy.
6 COUNTRIES THAT HAVE GONE THROUGH DEMONETIZATION
- Demonetization in the Soviet Union
- Demonetization in North Korea
- Demonetization in India
- Demonetization in Venezuela
- Demonetization in Australia
- Demonetization in Pakistan
In theory, demonetization can bring about positive monetary changes. A government might use it to end corruption or runaway inflation. They might also use it to improve the country’s macroeconomic policies. But history has repeatedly shown that if done without sufficient planning, demonetization has many negative ramifications that are unexpected. Rather than renewing trust in the government, it can cause a total loss of faith, and rather than establishing order, it can spark chaos. In fact, demonetization can be so disruptive that citizens protest, riot, and loot to vent their frustration.
A wise government will plan a smooth transition. It may, for example, issue a new banknote that looks similar to the previous one but with fewer zeros. This makes it easier for people to identify the currency and recognize its new value. The government will also link the nominal value of the new currency to a familiar foreign currency like the euro or the dollar so that people can understand its macroeconomic value.
WHAT IS DEMONETIZATION?
Demonetization occurs when a government bans a unit of currency by stripping its status as a legal tender. After a government demonetizes one or more units of currency, it organizes a way to pull the old unit of currency out of circulation and replace it with the new unit of currency. Usually, people go to banks or ATMs to swap out their old money for the new money.
If this currency swap is poorly implemented, it causes widespread confusion and panic within the country and the government faces widespread resistance to the change in the currency’s value. One common problem that occurs is when people continue to use the old currency unit and refuse to go to a bank to swap out their old currency unit because they fear a cash shortage. Therefore, illegal money may continue to circulate if people maintain an informal agreement to continue to honor the value of the deprecated currency unit. This may occur in remote regions of the country if the uneducated rural population did not hear about the new demonetization policy.
Another common problem is that the new currency unit may not replace the value of the old currency unit in circulation quickly. This can occur if the government has not clearly designated when the new money is available. Sometimes, the government gives people an unrealistic schedule to exchange their money. Consequently, people may experience a cash crunch if they do not have enough time to swap out their old currency because financial institutions throughout the country are so congested that people can’t get to banks or ATMs before the deadline.
Advantages and Disadvantages of Demonetization
Demonetization has several advantages. It can bring untaxed money back into circulation and help clamp down on corruption because it forces people to declare their unaccounted money.
Demonetization can also make it easier for a country to transition to a cashless economy by increasing a demand for more debit cards to facilitate electronic payments. Obviously, the more debit cards available to the general population, the higher the likelihood of cashless payments replacing cash-based transactions.
There are also many disadvantages to demonetization. It can create widespread distrust in the government, undermining any other political plans that the government needs popular support to implement. It can also impoverish people who can’t make the swap by the designated deadline because their money suddenly becomes worthless.
Demonetization can stir up massive public unrest. People will clamor for a new government, try to sue the government, express disdain for the new government policy through mass media, and march in protest in public places. Rioting, crime, violence, and looting may occur. This widespread agitation will then result in a government clampdown, which arouses even more public ire and popular uprisings. For example, when India demonetized 500 rupees and 1000 rupees, the Indian National League filed a Public Interest Litigation (PIL) to the Madras Supreme Court, requesting the court to intervene with the government to reverse the demonetisation policy. However, the Supreme Court refused to take any action on the PIL.
Demonetization has been known to disrupt the flow of goods and services throughout the country because people now have to spend hours in long queues at local banks to have time to convert their money from the old currency to the new one. Since standing in long queues takes up the time and attention of potential customers, many businesses lose revenue streams and experience financial losses. The domino effect of a disrupted consumer base affects the stock market and ruins the quarterly income goals of both public and private organizations.
There is also the risk of slowing down a country’s economic growth. Since it may take some time for the nation to acclimatize to the new monetary policy, demonetization often adversely affects the stock market and GDP.
6 COUNTRIES THAT HAVE GONE THROUGH DEMONETIZATION
Many countries have implemented demonetization. Here are six examples of what happens when a country goes through demonetization.
1. Demonetization in the Soviet Union
On January 22, 1991, Mikhail Gorbachev shocked the Soviet Union by declaring that both the 50-ruble and the 100-ruble note would be invalid at midnight that day. He also gave note holders only three days to exchange the old notes for new notes. Anyone who still possessed 50-ruble or 100-ruble notes would then have to make their appeal before special commissions to get their worthless notes replaced.
The purpose of this demonetization was to disrupt the informal economy—that part of the economy that the government could not formally monitor or tax because of their remote locations. This sudden restriction on the economy had unexpected long-term ramifications. Many economists think it may even have caused the collapse of the USSR, forcing it to adopt a democratic political system, one that communism had vociferously denounced since 1917.
Gorbachev’s demonetization policy stalled economic activity throughout the country. People quickly lost faith in the government, and Ukraine and Kazakhstan experienced an economic crisis. Later, in 1993, Moldova, Turkmenistan, Azerbaijan, and Georgia abandoned the use of the ruble. Instead of starting a currency reform, demonetization in the USSR destabilized the country, caused the collapse of communism, and ended Soviet influence in fifteen states from Armenia to Uzbekistan.
2. Demonetization in North Korea
Oblivious to what had happened in the USSR, North Korea tried something similar. Like the Soviets, they, too, experienced large-scale economic destabilization.
On November 30, 2009, the government issued a Draconian demonetization policy to crack down on private enterprise. It even confiscated old currency held by note holders. The chaos that ensued was so overwhelming that the government had to retreat and agree to reopen the private enterprise market.
Undeterred by the lessons of their own history, the North Korean government had completely forgotten why their people had become entrepreneurial.
They had forgotten that back in 1990, the North Korean economy had almost collapsed because the government had failed to maintain an efficient centrally planned economic system. By the mid-1990s, a half-million to a million people died of starvation, which was about 3 to 5 percent of the population. To survive the government’s inability to provide a livelihood, the Korean people became highly entrepreneurial with households, local government offices, and even military units developing small-scale private enterprises.
3. Demonetization in India
The people of India view the Indian rupee with profound respect because of its historical importance. The origins of this currency go back millennia, with the first rupee circulating in the 6th century BCE. This currency is one of the oldest in the world, part of the world’s first coinage, as intrinsic to the history of money as the Lydian stater or the Chinese wen.
When Indian Prime Minister Narendra Modi announced that he would ban 500-rupee notes and the 1000-rupee notes on November 08, 2016, it caused tremendous outrage in the country. In fact, the effects of this India currency demonetisation still stir bitterness in that country to this day. Although Modi started this currency reform to improve the country’s broken monetary system, he infuriated the people of India, who felt that he had violated their rights and used political machinations to steal their money.
Modi demonetized high denomination rupee notes to rid the economy of black money, but his efforts failed on many fronts. The banks only collected 10,720 crore, or $107.2 billion, only a small portion of the 500-rupee and 1000-rupee notes that the government had estimated to be in circulation. But that was not the only calamity: the stock indices of NIFTY 50 and BSE SENSEX also plummeted to six percent and the country’s industrial production and gross domestic growth rate underwent huge losses.
Ironically, despite how vehemently the people of India protested this new demonetization policy, the governments of other countries felt emboldened by Modi’s daring India demonetization policy. They did not even wait to observe the results but hastened to do the same a month later. Consequently, the governments of Venezuela, Australia, and Pakistan also declared that they would demonetize some of their currency units to solve their own monetary problems.
4. Demonetization in Venezuela
Venezuela was once the envy of South America. After geologists discovered vast oil reserves in the country, it enjoyed exponential GDP growth. By 1950, it was the 4th wealthiest country per capita income in the world. Journalists described the six-year dictatorship of Pérez Jiménez from 1952 to 1958 in glowing metaphors. They compared Venezuela to the oil-rich countries of the Middle East, to the cultural sophistication of the French Riviera, and to the robust economy of West Germany.
Now after decades of corruption, with each new administration blaming the one before it, this once-prosperous country has runaway inflation. At the time Nicolás Maduro’s government demonetized the valuable 100-bolivar bill, the rate of inflation analysts estimated the rate of inflation to be about 475%, with some claiming that it was already at 800% by the end of 2016.
On Dec. 11, 2016, roughly a month after Prime Minister Modi of India had declared demonetization of the rupee, Nicolás Maduro gave the citizens of Venezuela three days’ demonetization notice, warning them that the government would declare the country’s most valuable banknote worthless—although it counted for 77% of the cash in circulation. He fueled the ensuing panic by not declaring a definitive date when the government would replace the 100-bolivar note, only stating a higher denomination, somewhere between 500-bolivar to 20,000-bolivar, would replace the money.
Maduro’s plan was to disrupt the vast black-market sale of Venezuelan bolivars in Colombia, but it created repercussions that surprised him. Since he had given the country such short notice and only a vague outline of how and when the new currency would be available, his declaration sparked wave after wave of looting and violent protests throughout the country. Like the North Korean government seven years earlier, he was forced to retreat from his official stance. Under considerable pressure, he extended the deadline for the demonetization of the 100-Bolivar bill.
5. Demonetization in Australia
On December 14, 2016, Kelly O’Dwyer, Australia’s financial services and revenue minister, made a public announcement about how Australia was planning on demonetizing its $100 notes. Like Maduro, he demonetized the highest denomination; and like Modi, he wanted to shut down the shadow economy. However, unlike the Indian or Venezuelan government, the Australian government did not make the same mistakes. O’Dwyer floated the idea rather than issuing a demand. This led to public debates amongst analysts and did not stir any social upheaval.
6. Demonetization in Pakistan
On December 19, 2016, the Pakistani Senate, too, took on the gray and black money markets by phasing out the 5,000 rupee note. This note accounted for 30% of the rupees in circulation in Pakistan. Osman Saifullah Khan, the Senator who proposed the motion, was quick to distance himself from Modi since both Pakistan and India had clashed in the Indo-Pakistan war of 1965 over Kashmir and Jammu. However, the notion of demonetization did not stir up any public protests in Pakistan because the government rolled out a long-term 3-5-year schedule. The Senate also spelled out the benefits of such a move to the press—reduced tax evasion and the accumulation and hoarding of illegal wealth—to win over public sentiment.
How Can Demonetization Affect Currency Investing?
A currency demonetization will not have an immediate effect on your decisions on when to sell foreign currency because it will not directly affect a country’s foreign exchange rate. It will, however, have an indirect effect on the exchange rate in the long run because it will temporarily reduce the gross domestic product growth and discourage foreign investments.
WHAT HAPPENS WHEN A COUNTRY GOES THROUGH DEMONETIZATION?
Demonetization can cause nationwide protests, looting, and violence if the government suddenly takes a large amount of currency in circulation out of the economy. This causes widespread panic because people fear a cash shortage. Although the government intends to replace the old currency units with a new currency unit, the transition has to be well-organized. People should have enough time to get their financial affairs in order, complete any financial transactions in process, manage any outstanding payments, and they should also be able to get the new currency units as soon as they turn the old ones in. The longer the delay in arranging a swap, the more agitated the population will become.
Still, to do it properly, a government has to take into account its own history. This is what the USSR and North Korea both failed to do, causing irreparable damage to the welfare of the people and the state of the economy.
Another common mistake is to force an accelerated rate of change. This is an error that India and Venezuela made. Australia avoided creating chaos by talking about reviewing the idea rather than taking drastic action. This created space for public debates, discussions about financial inclusion, and public consensus on how to manage a demonetization.
Pakistan handled the process of demonetization in the best way. The Senate first spelled out the benefits of the proposal to the press to avoid creating a shock to the nation. These benefits included curtailing black-market operations, clamping down on tax evaders, removing any fake currency in circulation, and making it more difficult for people to accumulate wealth illegally. They then proposed a long-term plan so that people would have plenty of time to replace their old currency units with new ones. If done the right way, demonetization can bring about positive economic reform.