FALQs: Demonetization in India

The following is a guest post by Supreetha Sampath Kumar, a foreign law intern at the Law Library of Congress. This blog post is part of our Frequently Asked Legal Questions series.

On November 8, 2016, the Prime Minister of India, Narendra Modi, announced the “notebandi” initiative, declaring that the use of all Rupees (Rs.) 500 and Rs. 1,000 banknotes (equal to about US$7.60 and US$15.30) of the Mahatma Gandhi Series would cease to be legal tender past midnight that night. The public was given until December 31, 2016, to deposit their old currency in exchange for newly designed Rs. 500 and Rs. 2,000 notes. Foreigners in India holding demonetized currencies were given a deadline of January 31, 2017, and non-resident Indians had until March 31, 2017. The government imposed a cap on over-the-counter cash withdrawals of Rs. 24,000 (about US$355) a week for bank accounts and of Rs.4,500 (about US$66.50) a day for ATMs. However, there were no restrictions on non-cash transactions such as checks, credit/debit cards, etc.

In this post, I look at the reasons for the demonetization decision, how it was brought into effect, similar initiatives that have been implemented in the past, and legal challenges that have been brought against the policy.

1. What was the purpose of the demonetization decision?

Newspaper reports indicate that the government’s intentions behind the 2016 demonetization were twofold. First, it aimed to curb the circulation of “black money” and counterfeit notes, thereby fulfilling the Prime Minister’s pre-election campaign promise to take on corruption and black money in the economy. The Ministry of Finance indicated in its November 8, 2016 notification that fake currency notes of the specified bank notes (Rs. 500 and 1,000) have been widely circulated and their use in financing subversive activities such as terrorism and drug trafficking was causing an adverse effect on the economy.

According to a 2010 World Bank report, the size of India’s shadow economy averages 22.4% and ranks as the fifteenth largest among the 88 developing countries studied. It has been estimated by India Rating and Research (a credit rating agency and subsidiary of the FITCH Group) that with the ban of notes (worth a total of Rs.4 lakh crore, or about US$4,000 billion) in cash and fake currency, 12% of the black money will be terminated.

Second, the government aimed to promote a cashless, more digitized economy. However, some reports state that a “cashless economy” is an afterthought policy of the government in response to the reported negative effects of demonetization in India. The promotion of a cashless economy through demonetization is an initiative under Prime Minister Narendra Modi’s Jan Dhan Yojana – mission for financial inclusion.

2. Is India shifting to a more cashless economy?

Four weeks prior to the demonetization notification, the U.S. development agency, USAID, partnered with the government of India to create a network of organizations under the banner “Catalyst“ to increase the usage of digital payment systems, particularly among low-income groups. The purpose behind this partnership was to take a step towards financial inclusion – the facilitation of financial access through numerous electronic platforms, thus limiting cash transactions in the market. In 2016, USAID’s Beyond Cash report stated that 97% of retail transactions in India are in cash, and only 29% of bank accounts have been used in the three months prior to January 2016. In addition, only 6% of merchants accepted digital payments and 10% of consumers had used a debit card in the year 2015.

Since demonetization was implemented, there have been reports of a sharp rise in the usage of payment networks such as e-wallets, Visa, Mastercard, Paytm, etc., thus indicating that the policy may be simultaneously achieving financial inclusion. Certain opposition political leaders, including former Finance Minister P. Chidambaram, expressed doubts about the possibility of a “cashless society” in India, when transactions in other countries like the U.S. and Germany are still significantly in cash. The question of whether demonetization in India actually addresses the problem of circulation of black money in the economy has also been disputed.

3. How was demonetization brought into effect?

The 2016 demonetization policy was brought into effect through three legal instruments. The first was the Gazette Notification issued by the Ministry of Finance stating that in the exercise of its powers conferred under section 26(2) of the Reserve Bank of India Act (RBI Act), the central government, on the recommendation of the Central Board of Directors of the Reserve Bank of India, had declared that banknotes of the existing series with the denomination of Rs. 500 and Rs. 1,000 shall cease to be legal tender from November 9, 2016. Second, the Ministry of Finance issued a Gazette Notification specifying the new denomination of Rs. 2,000 notes. The third Notification was issued by the Reserve Bank of India (RBI) to the banks specifying the actions to be taken by the banks for people to exchange old denomination notes for the new series of bank notes, called the Mahatma Gandhi (New) Series.

The 2016 notifications issued by the government prohibit the transfer or receipt of banknotes that have ceased to be legal tender and restrict RBI’s obligation to exchange the old notes with new notes after a certain deadline. This is despite the fact that, under section 39 of the RBI Act, the RBI is under a continuous legal obligation to exchange old notes with new ones, thereby prohibiting the imposition of a specific deadline. However, researchers at the National Institute of Public Finance and Policy and the Indira Gandhi Institute of Development Research have pointed out that the “ultimate purpose of demonetization” – to curb black money stored in the form of cash – may not be achieved if there is no obligatory deadline for the exchange of notes.

In order to solve this problem, demonetization notifications in the past (in 1946 and 1978) have been followed by ordinances and laws to “specifically override” the statutory obligation under the RBI Act. In other words, to formalize the notifications and impose deadlines for exchanging old notes with new ones it was necessary to pass or promulgate laws to that effect.

Laws in India are ordinarily passed by parliament through a legislative process. However, the president does have special lawmaking powers, under article 123 of the Constitution of India, to promulgate temporary ordinances if both houses are not in session and if it is necessary to take immediate action. The underlying purpose is for the president to address any urgency that may occur when parliament is not in session. An ordinance ceases to operate if it is not approved by parliament within six weeks of reassembling (i.e. January 31, 2017). Under his lawmaking powers, the President of India, Mr. Pranab Mukherjee, promulgated the Specified Bank Notes (Cessation of Liabilities) Ordinance, 2016 on December 30, 2016, making it illegal to hold Rs. 500 and Rs. 1,000 notes after March 31, 2017. On February 27, 2017, legislation known as the Specified Bank Notes (Cessation of Liabilities) Act, 2017 was passed by the Parliament of India to continue to give legal effect to the demonetization.

4. Have there been attempts at demonetization in the past?

There have been two previous instances of demonetization in India. The first was in 1946 during the British Colonial period, when the government demonetized high denomination notes (Rs. 500 and above) to curb black market money and tax evasion. On January 12, 1946, the Governor General of India promulgated the High Denomination Bank Notes Ordinance, 1946, which withdrew the legal tender status of 500, 1000 and 10,000 rupee notes. Notes were to be exchanged for valid tender in accordance with a detailed procedure before January 22, 1946. Chintaman Deshmukh, the then Governor of the RBI expressed his opinion that the 1946 demonetization was “not a revolutionary measure and even its purpose as a minatory and punitive gesture towards black-marketing was not efficiently served.” By the end of 1947, notes with a total value of Rs. 134.9 crores (about US$19,926,144) were exchanged out of a total issue of 143.97 crores (about US$21,265,878.8). Therefore, only Rs. 9.07 crores (about US$1,339,734.12) were “demonetized”.

The Ordinance was challenged  by a person acting as an accountant for a temple trust before the Allahabad High Court in B Ram Lal v. State (AIR 1954 All 758) on the grounds that the right to acquire, hold and dispose of property under the Constitution of India was violated. Specifically, the constitutional validity of sections 3 and 4 of the 1946 ordinance was challenged alleging that these provisions were in violation of article 19(1)(f) of the Constitution. The court held that

[u]nder  of  the Constitution, what has been guaranteed is the right of every citizen to acquire, hold and dispose of property undoubtedly places a restriction on the power of disposing of and acquiring high denomination bank notes after a certain date, and high denomination bank notes must be held to be property but Article 19 is subject to the restrictions mentioned in Clause (5) of that Article. Under Clause (5), the State could make any law, imposing reasonable restrictions on the exercise of the right of a citizen to acquire and dispose of or hold property in the interest of the general public. The impugned Ordinance was passed because an emergency had arisen because of great currency inflation and restrictions were placed because such restrictions were necessary in the interest of the general public. (B Ram Lal v. State (AIR 1954 All 758), paras. 101, 102).

The court upheld the constitutionality of the Ordinance by concluding that “[o]nce the high denomination bank notes ceased to be legal tender, any restriction on their transfer to another person cannot be said to be unreasonable.” Moreover, the Court held that since the Ordinance provided for the exchange of high denomination notes for smaller denominations, it could be considered a reasonable restriction. (Id. para. 104.)

India’s second experience with demonetization was in 1978, when the public was given three days to exchange their 1,000, 5,000 and 10,000 rupee notes. According to the then Finance Minister, Mrs. H. M. Patel, “[t]he demonetization of high denomination bank notes was a step primarily aimed at controlling illegal transactions. It is a part of a series of measures which Government has taken and is determined to take against anti-social elements.” The concern that drove the government to take this step was the behavior of agricultural prices, in particular rising prices in spite of a bumper harvest and massive imports of edible oil failing to bring down prices of mustard oil. A total of 73.1 crore (around US$1,139,451) was demonetized, 1,067 crores (around US$166, 312, 116) and 650 crores of Rs. 100 notes and other denominations were added into the economy. The process failed to destroy any money stock.

The demonetization in 1978 was introduced by an ordinance, which was then replaced by the High Denomination Bank Notes (Demonetisation) Act, 1978. The Act was challenged before the Supreme Court in Jayantilal Ratanchand Shah v. RBI (1997 AIR 370) on the grounds that it violated the fundamental right to trade under article 19(1)(f) and 31 (now repealed) of the Constitution of India. The five judge bench in this case held that the purpose of the Act was “to prevent unaccounted money from being used for financing illegal activities and preventing the state from realizing the revenues therefore demonetization served a public purpose and since the Act provided a procedure for obtaining equal value of currency notes being exchanged hence there was no compulsory acquisition.”

The Supreme Court emphasized that the time limit imposed for exchange of the high denomination notes was necessary in order to cease their circulation as early as possible. The Court held that “if the time for such exchange was not limited the high denomination bank notes could be circulated and transferred without the knowledge of the authorities concerned from one person to another and any such transferee could walk into the Bank on any day thereafter and demand exchange of his notes. In that case it would have been well high impossible for the Bank to prove that such a person was not the owner or holder of the notes on January 16, 1978.” The Court therefore upheld the constitutionality of the Act.

5. What legal challenges does the 2016 demonetization face?

Writ petitions have been filed by advocates on behalf of individuals/organizations in the High Courts of Kerala, Bombay, Delhi, Hyderabad, Gujarat, Karnataka, Calcutta and Allahabad questioning the constitutionality of the notifications. In addition, a petition before the Supreme Court of India filed against the Ministry of Finance and the Reserve Bank of India claims that “fixing the date from which demonetization would come into force is the substratum of power under section 26(2) [of the RBI Act] and constitutes an “essential law making function” which cannot be delegated to be fixed by the central government on its own determination.” The issue arises in the interpretation of the word “series” in this provision, i.e., whether the government can withdraw legal tender of “all” bank notes of one or more denominations. According to Prabhash Ranjan, an assistant professor of law at South Asian University, “[s]ince the RBI Act does not define the word ‘series’, it is unclear whether ‘series’ in Section 26(2) refers to the broader category of the ‘Mahatma Gandhi series’ of banknotes that the RBI launched in 1996 – and has since been replaced by the Mahatma Gandhi (new) series from November 9 – or whether ‘series’ refers to the narrower category of different serial numbers with different inset letters printed on the banknotes.”

It has been argued by Indira Jaising, a senior advocate of the Supreme Court of India, that if the intention of the legislature was to vest the government with the power to withdraw the legal tender of “all” bank notes of a particular denomination, then the use of the word “series” under section 26(2) of the Act would be entirely redundant. The demonetization of the banks notes would be consistent with section 26(2) if the government is able to prove to the courts that the decision was made based on the recommendation of the RBI’s Central Board of Directors, since RBI has sole authority to operate the currency and credit system and to decide their legal tender status, whether it should include “all” or “few” series of bank notes.

The Madras High Court (in M Seeni Ahamed v. Union of India) dismissed the public interest litigation filed by M Seeni Ahamed, State General Secretary of the Indian National League, who sought an order that the central government reverse the decision to demonetize 500 and 1,000 rupee notes and to make them legal tender again. The court referred to the Supreme Court decision in S.R. Bommai v Union of India (AIR 1994 SC 1918) which concluded that “where the decision is one which does not alter rights or obligations enforceable in private law, but only deprives a person of legitimate expectations, procedural impropriety will normally provide the only ground on which the decision is open to judicial review.”

On December 16, 2016, the Supreme Court bench hearing petitions asking for the notification to be quashed stayed all the matters pending before the High Courts and refused to interfere with the implementation of the policy and also declined to extend the deadline for accepting old notes outside the RBI. The Supreme Court established a five-judge bench to examine the constitutional validity of the government’s decision to take Rs. 500 and 1,000 notes out of circulation. The Chief Justice’s bench has framed nine questions for the Constitution bench, including whether the decision was in violation of the RBI Act and other constitutional provisions, whether the implementation suffers from procedural unreasonableness, and whether the curbs on the withdrawal of cash from bank accounts has any legal foundation. The case has not yet been scheduled for hearing before the Constitution bench.

At present, the fundamental question before the Supreme Court is whether the Court should intervene in matters that come under policy decisions of the government. It has been held by the Supreme Court in the past that it is not mandated to interfere in the policy decisions of the government, except where such policy decision is afflicted with some “fundamental infirmity” such as being unconstitutional. The Supreme Court in DDA v. Joint action Committee, Allottee of SFS Flats (AIR 2008 SC 1343) held that a policy decision of the government is subject to judicial review when the policy decision is unconstitutional, if it is de`hors´ [outside the scope of] the provisions of the Act and the regulations; if the delegate has acted beyond its power of delegation; or if the executive policy is contrary to the statutory or a larger policy.