On November 8, 2016, the Indian government made a surprise announcement that certain currency notes (representing 86% of the currency then in circulation) would no longer be legal tender (although they could be deposited in banks for a limited period). The stated reason for this sudden ‘demonetization’ was to combat tax evasion and corruption associated with ‘unaccounted-for’ cash. In our paper, we use daily stock price data from the Prowess database (maintained by the Centre for Monitoring the Indian Economy (CMIE)) to compute abnormal returns for firms on the Indian stock market around this event. In particular, we compare patterns of abnormal returns for different subsamples of firms defined by industry, ownership structure, and other characteristics.

There is little evidence that sectors thought to be associated with greater tax evasion or corruption experienced significantly different returns. The real estate sector, where payments in unaccounted-for cash are thought to be a widespread means of tax evasion, experienced an abnormal return of between -2% and -4%. We argue, using a simple theoretical framework, that this is consistent with a market expectation of only a modest decline in tax evasion. Similarly, we find no detectable relationship between the abnormal returns we compute and an index of sector-level perceptions of the prevalence of bribery (constructed by Transparency International based on global survey data). Overall, these findings suggest that the market expected the effects of demonetization on corruption and tax evasion to be modest at best.

It is possible that Indian firms that are more ‘foreign-facing’ are less prone to corruption due to the influence of external norms and laws. However, we find no evidence of a differential effect for firms with export revenues. We also find no evidence of a differential effect for Indian firms cross-listed abroad in non-US markets, or for those that issue shares to US investors through private placements or Rule 144A offerings (without becoming subject to US securities law). We find positive abnormal returns for Indian firms listed on a US exchange, and thus subject to US securities law and to the US Foreign Corrupt Practices Act (FCPA). However, the small number of firms in this category makes it difficult to reach definite conclusions.

The most striking findings of our paper are substantial positive abnormal returns for banks and for state owned enterprises (SOEs). Each of these results imply market expectations that are puzzling in some respects. Banks experience an abnormal return of about 3% to 7% (depending on the specification). This result appears to indicate a market expectation that demonetization would result in a persistent increase in financial sector deposits (rather than the transitory increase that a demonetization, followed by a remonetization as new currency notes are issued, might be expected to create). Indeed, the observed reaction requires that the market believed that demonetization would lead to a substantial and persistent shift in the form of savings by the public in India, from unaccounted-for cash to bank deposits, and thus to an increase in the economy’s financial depth. Consistent with this, we also find a pattern of higher abnormal returns for industries that are characterized by a greater dependence on external finance, possibly suggesting an expectation of an easing of financial constraints.

The abnormal returns for SOEs – of about 2% to 6% (depending on the specification) - are also difficult to explain. While many of India’s banks are SOEs, our result holds for both bank and nonbank SOEs. Ultimately, we argue that these results may be due to possible indirect effects of the announcement on perceptions of future corruption among SOEs, either because they are particularly prone to corruption due to their political connections, or because they are particularly subject to the effects of government crackdowns on corruption.

The stock market’s reactions are merely the earliest assessments of the effects of demonetization. Nonetheless, for our main results, there is no evidence for the reversal of the initial reactions over the subsequent five-month period. In general, stock market reactions represent useful information from parties who have strong financial incentives to predict these effects correctly. It is sometimes said that journalism is the first rough draft of history, and the stock market reactions analyzed in this paper can analogously be understood as a first draft of the story of the impact of this important policy and its wider implications.

Dhammika Dharmapala is the Julius Kreeger Professor of Law at the University of Chicago.

Vikramaditya S. Khanna is Professor of Law at the University of Michigan.