Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Economics of counterfeit notes

There has been much alarmed discussion in the press about the
counterfeit Indian rupee notes allegedly being smuggled into the
country from across the border. As I see it, the barriers to
counterfeiting currency notes are economic and not technological.

Introducing more and more complex features into the notes does not
make counterfeiting impossible. What it does is to increase the scale
economies in printing by requiring larger and larger initial
investment and therefore larger and larger scale of production to make
the printing of counterfeits economical. Scale economies are not a
problem for the government itself because it anyway prints notes on a
very large scale.

Scale economies need not deter the counterfeiter; it only requires
the counterfeiter also to operate on a large scale. The problem for
the counterfeiter is that the distribution of counterfeit notes is
characterized by large diseconomies of scale.

It is pretty easy to distribute a few hundred counterfeit notes
with very little chance of detection. Distribution of a million
counterfeit notes however requires a distribution network that is very
difficult to set up and operate without being detected.

This combination of scale economies in production and scale
diseconomies in distribution imply that there is often no viable scale
of operation for a private counterfeiter. The total expected cost of
manufacturing and distributing the counterfeit note approaches the
face value of the note itself.

Counterfeiting by a foreign government is only slightly
different. To the extent that they can use the equipment used in their
own note printing operations, counterfeiting may be economically
viable for them at lower print runs. More importantly, if their goals
are not purely economic, the profitability of the operation is not an

However, the problem of the distribution channel is still an
issue. The experience of German counterfeiting of UK currency notes
during the second world war suggests that the technical quality of the
counterfeiting is not the real problem. How to get the notes into
enemy territory in large scale is the critical issue. The German
experience suggests that using the espionage network to put the notes
into circulation only compromises the espionage network itself.

Often, the goal of putting counterfeit notes into circulation in
enemy territory is not to make a profit but to disrupt the
enemy’s economy by making people distrust their own
currency. The strategy of the Indian government and the RBI to deal
with the problem of counterfeit notes quietly and without spreading
panic is therefore a very sensible one.

For a profit motivated rogue government, the most attractive
currency to counterfeit is the US dollar. An estimated 70% of US
dollar notes circulate outside the US; many users of the currency are
not very familiar with it; the design of these notes is relatively
stable; and finally, dollar resources are very valuable in
international trade.

Anecdotal evidence suggests a greater percentage of counterfeit US
dollar notes (at least outside the US) than in most other
currencies. Yet the percentage of counterfeit notes is still quite
manageable. I think therefore that the fears that are being expressed
in the Indian press about counterfeit rupee notes are excessive.


One response to “Economics of counterfeit notes

  1. Alex Dalmady August 19, 2009 at 4:27 am

    Nice Post. Interesting and revealing as usual.

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