A lot of froth has been generated over the recent demonetization exercise by the Narendra Modi Government. The event itself took place on the 8th of November and announcements made late evening to the utter shock of the masses looking bleary eyed, after their currency notes of Rs 500 and Rs 1000 ceased to be legal tender w.e.f midnight. The move sparked panic on the streets , long queues in Jewelry shops, shopping malls and shady enterprises that took in their old notes for lower denomination notes.
This move is very controversial, since there hasn’t been any precedent of a large economy the size of India , which basically removes 86% of currency notes in circulation. What happened next is a sequence of policy decisions regarding exchange, deposit and withdrawal of notes from bank. Cash is the blood of the Indian economy, but now the very life out of the economy is being taken out by this daring executive decision.
Modi, the expert communicator that he is, has reached out to his voters by ways of telecasting on TV, and his own apps on smartphones. arguably, he still maintains his popular ratings despite caustic attacks by the opportunistic opposition parties, who seemed bereft of any cogent ideas to corner the BJP government.
But, any move has its consequences, no matter how much the government wants to wish away its evil. One very scary prospect is the risk of deflation. This means a drop in prices all around. Why this happens is that consumers hoard whatever cash he/she has and uses it only for most essential uses like food and fuel. This causes immense stress on the sectors of the economy which depend on discretionary expenses of the consumer. Hence we should expect consumer goods and real estate and even FMCG feeling the heat due to loss of purchasing power. This is live demonstration of deflation at work, perhaps the first in independent India. One just needs to see state of affairs of government controlled mandis where there’s practically no demand for farm produce causing farmer distress.
The government on its side, has claimed to have extinguished significant amounts of black money in this exercise. Critics of the move will scream conspiracy citing the big ticket elections of UP and Punjab in 2017. But such an argument is not a convincing one as elections are held every year in one or more states each year. The real reason for the move might very well be to bolster the strongman image of Modi among his voter base. That he has almost antagonized the trader’s lobby due to this move as well as the pushing through the GST , proves that Modi is willing to take tough measures for the nation as a whole which wasn’t possible during the coalition politics of the previous two decades.
Opponents have cringed at this move. Mihir Sharma in this piece on Bloomberg has called the move a “vegan fallacy” and a “moral project” , not an economic one. Some others like Ruchir Sharma (of the breakout nations / rise and fall of nations fame) have suggested that retributive justice is no development strategy. Writes Ruchir, “The impassioned debate obscures a basic problem with the demonetisation scheme, which is that it presumes to know what comes first, development or growth. In general, institutions grow stronger as a nation grows richer. India cannot expect to leapfrog up the development ladder simply by purging black money from its system. Certainly no other nation has done it that way.” One would tend agree that he’s broadly on the right track but misses the elephant in the room. Indians have culturally been trained to bend or break rules. If that weren’t the case previous measures to hit black money wouldn’t have been a miserable failure. People appreciate bold daring action and not just mere legislative paperwork. This may very well be the reason why that even after more than a month after the fateful announcement, common man on the street still is patient and we’ve still not seen riots over cash dispensation.
Modi may have thought that it’s better to take big notes out of circulation because hiding black money in cash is difficult when higher denomination notes aren’t available. Imagine giving a bribe of 1 crore all in 100 rupee notes. Besides taking up a lot of space carrying so much cash is conspicuous invitation to law enforcement agencies. Besides this practical aspects, one doesn’t really know how much black wealth is hidden in cash or already converted to other forms like bullion or forex or shady real estate deals.What happened is that even the government has no estimation of the total amount of black money in the financial system. This is something that the finance minister Arun Jaitley told the Lok Sabha in a written reply to a question that had been asked by Anant Kumar Hegde, a BJP Lok Sabha MP from Karnataka.
As Vivek Kaul rightly points out in his piece, “…such a huge decision that impacts every citizen of this country was made, even without taking a basic estimate of black money into account. Of course, all big decisions in life, require some leap of faith. The perfect data and the perfect conditions are never there. But at the same time there should be some analytical basis to them as well. There must be some expectations of a payoff for the government that will make it worth all the trouble that the people of India have been be put through.”
But one needs to gt hold of some numbers to judge the the demonetization exercise as a success failure or somewhere in between. Of the Rs 14 lakh crore worth of Rs 1,000 and Rs 500 notes declared illegal tender on the midnight of 8 November, Rs 11.55 lakh crore has found its way into bank deposits per statement put out by RBI . So it’s a fair guess that the major part of the remainder will also com into the system meaning that , the cash that will stay out may well be under Rs 2 lakh crore, which the Reserve Bank of India (RBI) can write off from its liabilities and hand over as dividend to the government. We only know this for sure after December 30. Also the time taken to push in new notes will take at least 4 more months (read more here). Hence in this case , we might well call the demonetization a failure owing to troubles created for common man.
Another argument made by supporters is the possibility of bank rates being reduced due to banks being flush with cash from this crisis. But, this may not be the case as rates affect not only the borrowers, but the savers as well . A crash in deposit rates will hurt senior citizens the most, as they rely on fixed interest instruments for their earnings. A crash in FDs also means people have to save more to earn the same return and this might not be what the government wants, due to lack of consumer spending accentuated by the crisis. Another dilemma rising from lower rates is the urge to lend without due diligence. With PSU banks reeling under bad loans , do we want another round of bad loans saddling the system? To be sure bankers have learnt the hard way seeing net worth of the banks sink and seeing the prospect that HDFC is of more value than entire PSU banks put together (ex-SBI). Banks will do well to take the treasury gains (due to fall in bond prices) instead of risking more bad loans by low due diligence
The biggest winners after demonetisation are e-wallets and electronic transactions. From card companies to mobile banking to e-wallets, everyone is reporting a surge in volumes. This part of the move towards a cashless society is already a success, but long-term success means there should be no reversal to the mean or a slide back towards cash once the situation eases. Psychology is key here. This writer assumes the cash shortage which is, at this moment natural due to lack of currency, may become artificial beyond 1st quarter of 2017. This is because the chances people will revert to cash once the circulation limps back to normal. Anecdotally this can be seen as small shopkeepers and vendors are again asking for cash as more notes are available. The fact that e-wallets aren’t that much popular with many in the lower income group doesn’t help the cause either. The crisis would have been wasted if digital and non-cash payments are not speeded up. Organised sector wage payments should be shifted to cheque and electronic transfers, and the first priority must be to minimize cash in urban transactions, starting with the metros, going to the smaller cities, etc. It is only the rural sector that needs more leeway with cash, and not urban centers. One would also wager that the government , in order to push use of e-money, will keep the notes in circulation to a level just necessary to keep the wheels of the system running. To be sure , e-money has also its shortfalls like poor security and need for internet connection which , beyond urban areas is still a dream.
As R Jagganathan writes in his piece, “..another yardstick to measure success is the extent of GDP fall, and how soon the revival happens. A 0.5 per cent fall in GDP growth rate in 2016-17 is par for the course, but anything above that will be costly, as a 1 per cent fall means a Rs 1.5 lakh crore drop in output. But this measure will not be known for at least a year, as we also must calculate if there is a sharper rebound after April 2017, which will make up for the losses in the last two quarters of 2016-17”
One should also remember that despite privatization and new age banking, the rent-seeking behavior in the banking sector hasn’t really gone away. In fact the rot has only been exposed in open by reports of bank managers arrested for “managing ” exchange of new notes for old tender, back door operations by money launderers to push ill-gotten wealth into Jan-Dhan accounts, and the biggest scam of co-operative banks in Maharashtra used to as a conduit to turn black money into white. Such dark misdeeds bring into question the efficiency and utility of the government’s own machinery and the governments needs to be fleet footed in such cases. It also needs to walk a thin line between law enforcement and tax terror.
The demonetization has to be complemented with tax reforms, law enforcement, and pushing of digital money on a war footing. Just focusing on one will lead to a lop sided result.