Demonetization in India – what does it achieve?

Now that the dust cloud and the chaos created by the government of India’s move to demonetize 87% of India’s cash has settled down, one is in a better position to see and understand the move. So on Nov 9, Modi made an address to the nation that shocked the world. He did something which no one had foreseen, and took a step no one had thought even he’d have the audacity to take. The beauty of the move certainly lies in its suddenness, as does the negative impact is has on the lives of millions of ordinary citizens. I am not going to discuss the intricacies of the decision, as I trust most of you already know about how it works and what everyone needs to do to exchange their money.

Modi, in his speech when he made this announcement, said that this is a nation of honest people, and gave passionate examples about the honesty of rickshaw drivers etc. Is this really true? Are we a nation of honest people? I know the PM’s job is to inspire, but I think Indians are one of the most dishonest people I’ve come across. Without delving into the details about the dishonesty of Indians at all walks of live, from the corruption involving top bureaucrats and politicians, to an ordinary shopkeeper not maintaining his accounts correctly, corruption permeates almost all aspect of an Indian’s life. Sure there are an equal number of honest people in India, but hey, we need to have an honest conversation about the magnitude of this problem, and as someone who has seen this nation (and many others) closely, I can say that corruption is endemic to India.

As soon as this move was announced, I started hearing about ponzi schemes to help convert your unaccounted cash into white money for a certain commission. Gold was sold out on day one. After that, gold was being sold for Rs. 51000/10 gms and the US dollar at Rs. 130 a piece if you wanted to buy it using the older notes. Similarly, there were people who hired poor people to deposit their money for them into their  accounts and repay them minus a commission, forcing poor people into the toxic cycle of corruption. Agricultural income being exempt from income tax also provided the perfect opportunity for people in power, especially in rural areas, to exploit this privilege. However, given the size of the country and the secrecy of the operation, only a small percentage of the guilty could have possibly escaped through these devious means.

A decision of this magnitude must have take years to plan. This means that the Modi govt. has been planning this stroke (masterstroke if you like) since it took office. There is no way such a huge move, with massive ramifications could be pulled off without extensive planning and deliberation. I know that many people are unhappy with the planning, but they are referring to implementation related loopholes, which are different from the planning I am talking about at the very top level.

A point worth considering is the political gamble, if not suicide, Modi has taken with this move. It hits right at the heart of his core constituency, middle class traders who run small shops and other businesses all over India. Many of these are also Gujaratis, who are known to be good businessmen. I think he deserves a lot of respect for taking a step, irrespective of our opinions about the step, that has the potential of turning the masses against him. This sort of conviction is what we’ve been lacking for far too long. So far, all the rhetoric about black money was limited to ‘Swiss banks’, and that was convenient for Indians who thought they needn’t worry unless they were among the handful who had Swiss bank accounts. But Modi did what I hoped the govt. would. Focus on things within the government’s control instead of going on and on about alleged wealth stashed in Swiss banks.

I also loved the fact that the move was planned and executed in such a way that the parliament and states were not involved. I know this is a contentious thing to say in a federal democracy, but we all know what would have happened if Modi had relied on the states to assist him with this step. There are some legal complications that will come to light soon, including assessments by senior lawyers that the move is technically illegal and contravenes section 26A of the constitution, which requires the govt. to use the parliament as a route to make such a move. I do believe this was possible via an ordinance, which could be secretly sent to the president for consent. This would ensure that the move will not be deemed illegal by the SC, which might well now be the case. Although, even if SC takes that view, the bullet has been fired, and there is no way of cancelling or rolling back the move.

Let’s move on and look at five things this move got right:

  • Element of surprise: For me, the fact that this was not even known to all members of the cabinet was the biggest win. I can personally attest that BJP MPs did not know about this impending move. This was sheer brilliance. The PM did not want anyone, including members of his own political hierarchy, which stretches from the ministers to the gram panchayat representatives to know about this, for several of those people are guilty of tax evasion and corruption. Similarly, the whole bureaucratic machinery didn’t know, and they are perhaps guilty of the most corruption. Even the IT department didn’t (and rightly so) know. No one had a head start. Now, Mr. Kejriwal can accuse the BJP of depositing huge amounts in the bank, but even if he is right, all of the BJP’s top guys put together constitute a minuscule percentage of the people and the wealth this targets. And this is based on the assumption that Mr. Kejriwal’s assertions are true.
  • Tackling counterfeit currency and terrorism: In one move, almost all counterfeit currency in circulation was wiped out. There is ample evidence that most if not all counterfeit currency was in 500 rupee notes, and since this move, every such note becomes valueless (as it actually is) and can’t reenter the economy. This also has a direct impact on terrorism funding, which is often done through counterfeit currency and ‘hawala’ transactions. A big win.
  • Liquidity for banks: By squeezing the liquidity out of the cash economy and pumping it into banks, this move has ensured that Indian banks don’t face a liquidity crunch for the next several decades. Having ample liquidity will allow the banks to lend at better rates which will directly benefit individual and institutional borrowers, proving the much needed catalyst to the economy. Because this move will have a deflationary effect on the economy, it will balance out any inflationary effect lower interest rates will have.
  • Encouraging people to move into the banking system: Every critic of the move talks about the fact that only 40% of India has bank accounts, or that in their specific constituency, most people don’t have accounts etc. No one asks them WHY? Why is it that only 40% of Indians have bank accounts after 70+ years or independence? Having most Indians participate in the banking system has several benefits. Among the most important ones is the fact that it allows the govt. to have a comprehensive digital identity chain that links PAN, AADHAR cards, and bank accounts. Not only does this help in improving overall efficiency, but also helps in ensuring transparency, especially when it comes to providing benefits and subsidies to the poor. Imagine the billions that are annually provided to distressed farmers (and are gobbled up by the states and the local machinery) could be directly put into the farmers account in a matter of minutes. There is no other way forward; we have to get people into the banking system and have a comprehensive identity framework that is interlinked. It opens up millions of possibilities.
  • Redistribution of black money (crucial read): The reason I have mentioned this last is because there has been too much focus on ‘getting rid of black money’ as part of this move. Sure, it is a big thing, but the other benefits are not trivial. Anyhow, one of the main objectives of this scheme was to tackle black money. How does it achieve this aim? And does it do it well? Firstly, cash is a small but important component in the black wealth ecosystem. Much more black wealth is invested in gold and land, but the govt. needs to tackle that separately and urgently.In one stroke, most of the black wealth held in India as cash has been wiped out. I’ll tell you how that is the case, and how that money can be now effectively redistibuted to the poor of the country. With the move, the govt. has been making it clear that this is NOT an amnesty scheme. In fact, there have been a lot of people who have been wondering as to why there is no amnesty on offer as people with black money don’t have the incentive to declare it, pay a fine, and move forward. Instead, the govt. has been talking tough by clarifying otherwise and making statements that transactions above Rs.250000 will be flagged for the IT department.This has been done to ensure that the corrupt who hold large sums of black money in cash DO NOT deposit their money into the banks. The idea is counterintuitive, but the govt. does not want them to deposit or catch them. They know that the crooks won’t go to the bank with Rs. 5 crore to deposit it as that would be sounding their own death knell! Given the statements that the govt. has made, they expect to be caught, and because this is no amnesty scheme, they will be criminally prosecuted for having money that was either received as bribes or through other more serious forms of corruption. These people have a choice. Lose the money (or at least most of it) or deposit it while risking a jail term. And I suspect they choose the former, especially public servants and bureaucrats.An easy way to know that this is indeed the case is to see news reports about people burning piles of cash or dumping them in isolated places. Why would anyone dump money? Money that can be exchanged for newer currency. Because that money was not just black; it was acquired by means that will be deemed criminal, and therefore, if the holders were to be investigated, they risk jail terms. Moreover, it would be foolish for the govt. to hand millions of cases for investigation to the IT department, who have been severely hit by this policy. If that were to be the case, the IT department officers would just focus on replenishing their coffers, which have been emptied by this move.Now, what happens to all this money that people DON’T deposit for the reasons explained? Do we lose this money? No. And I’ll explain how. Figure this: the RBI knows how many 500 and 1000 notes were in circulation, and therefore their total value (conservatively 83% of 16 trillion rupees, which is around 13 trillion rupees). Let’s call this number X. After December 31, the RBI will also know the total value of the 500 and 1000 rupee notes that have been deposited into all the nation’s banks. Let’s call this number Y. Even if several people were able to sneak in their black money into banks by devious means, as I explained, the bulk of black money obtained illegally will be lost as the people who hold it can’t deposit it into banks.

    When we subtract Y from X, that is total amount of currency deposited and in circulation respectively, we get Z, which is the total value of currency that the bad guys did not deposit in the banks to escape the possibility of criminal investigation. This money has now been sucked from the homes of these people and has been effectively redistributed to the treasury. The govt. can simply print currency up to the value of Z without impacting inflation, or even better, use it digitally to balance their books or pay for subsidies etc. If one percent of the total value is what is NOT deposited and can be therefore be written back to the nation’s treasury, it will add up to be around 130 billion rupees. Similarly, at 5 percent, we are looking at more than 750 billion rupees (USD 10 billion), which is more than India’s annual trade deficit.

Similarly, let’s look at five things this move didn’t quite get right:

  • Focus on black money: For me, too much focus was spent on positioning and selling this as a ‘surgical strike’ against black money. As I have already explained, getting rid of a small component of the black wealth economy (that being the black money) for a temporary period of time is one of the things that this move will achieve, but is in no way the only thing. Plus, the more they talk about black money, the more the disappointment that they will have to face as this move can only achieve so much when it comes to black money. In fact, anyone with a basic understanding of economics will understand that this move only gets rid, at best, of the cash section of the stock of black wealth. It cannot and does not do anything about the non-cash component, and the generation of new black money, measures for which must follow this move. Taxation reforms and political funding reforms are two of the biggest steps we need to augment this move.
  • Underestimating the impact on people: From the day this move was announced, I’ve heard govt. representatives and BJP spokesperson empathize with the difficulties faced by the common people of India, but dismiss those as temporary inconveniences. I have to say that the impact on the lives of several millions is more that of an upheaval than an inconvenience. Daily wage labourers, common people trying to travel by rickshaws, people wanting to buy and sell stuff due to it being Rabi crop sowing season, weddings being cancelled, deaths because hospitals didn’t know what to do etc., there are countless examples where the impact of this move is not as trivial as what the govt. makes it sound on TV.I don’t know whether they understand the impact but downplay it on purpose, or just plain don’t understand the impact. My opinion is that given all the benefits, such a move was overdue, because without such action, we’d be where we are (or worse) in 50 years from today. I contend that the poor people of India die a little bit everyday, and with this, they are dying slightly more than they usually do. I am unmoved by reports and comments such as this move has exacerbated the state of affairs in govt. hospitals. People say that govt. hospitals accept new notes but don’t have change. True. But what was the state before this move? Weren’t patients being treated on the floors of waiting areas, women delivering babies at the staircases, poor people paying bribes to get their loved on a bed in the hospital? Where is the outrage about this by the opposition parties, given that all of this happens BECAUSE of corruption and unaccountability? Shouldn’t the country unite and ask for accountability to be fixed when 130 people die in train accident? But apart from political bickering, have you heard anything in that direction when effectively a few people have murdered 130 citizens of India?So, I am saying that it is a major blow to the common man. But it is a necessary blow, especially if it can be followed up with several other steps that will make this pill easier to swallow. The govt. has been off target on this front and for me, the bitter truth that this is a major disruption would be easier to digest than a dose of sweetened syrup about this being an inconvenience. I also think that this would have added to the enormous fervor that this move has generated in the nationalistic circles.
  • Poor planning (and implementation): The implementation is poor, but then which govt.program has been implemented well in India? So we’ll talk about that in a minute, but first, let’s focus on planning. I think that the govt. had been planning this move for 2 years, and though it has done it reasonably well in terms of maintaining secrecy, there is more it could have done to mitigate the impact on people’s lives, especially knowing that the implementation WILL be shabby.To begin with, the govt. should have slowly increased the number of 10, 50, and 100 rupee notes in circulation, as they should have foreseen that even after sufficient new notes are disbursed, there will be a chronic shortage of change. For example, even before this move, if you were to use a 500 rupee note to say buy milk, you’d usually be pestered for the exact change. Imagine what would and has indeed happened now that people are using 1000 and 2000 rupee notes to buy the same stuff.Similarly, the recalibration of ATMs should have been done before the plan was rolled out. It could have saved a lot of people a lot of time and energy would ATMs be able to accept and dispense the new notes. Or perhaps, new notes should not have been of a new size. Another area which has disappointed me is that the new notes don’t seem to have any particularly enhanced security features. Not withstanding the plethora of FB videos of people washing the new notes in an effort to test their authenticity, an effort of this scale should have had more than a perfunctory focus on ensuring that the newer notes are harder, if not impossible, to replicate.Specific examples of other problems include the fact that private hospitals, which cater, by some estimates, to 75% + of all patients, were not exempted from this decision. The district and rural cooperative banks were not allowed to offer currency exchange. This was probably a way of rationing the new currency notes (there simply weren’t enough to have these banks exchange them as well), but that has resulted in undue advantage for the urban people. The impact on tourism wasn’t properly gauged and no clear guidelines were issued to minimize the troubles faced by international tourists.The timing of the move is also debatable because it was announced at the start of the Rabi crop sowing season. There could be a worse than anticipated impact on agricultural productivity, and I hope the govt. and the RBI have thoroughly studied this possible problem.

    As mentioned before, the fact that states were completely in the dark about this move, almost guaranteed poor implementation, because for any policy enacted in Delhi, the onus of implementation rests primarily with the states. This is not to say that the states would have done a good job. In fact, their, if they would have known, it would have done more damage than mitigate any problems, for they would have an opportunity to get rid of any illegitimate personal wealth and would have been as miserable as ever on the implementation front. So, at least, one can be happy that state level political leadership did not get a chance to escape either. With implementation hurdles, one has to remember that implementation is done by Indians; which scheme as ever been implemented well in India? But at least in this case, the fear of implementation hurdles did not deter an otherwise brave political move.

  • Negative impact on the informal sector: 45% of India’s GDP comes from the informal sector, which almost runs entirely on cash. The impact on the lives of people who participate in this sector (I’d estimate around 3/4 of India) is massive, and certainly unwarranted, as they were not the ones hoarding black money anyway. A surgical strike targets very specific areas. As the supreme court noted, this move is more like a carpet bombing exercise. You blow up everybody; surely, you’ll eliminate the bad guys too.
  • Hit on growth rate and possible recession: Given that this move has sucked liquidity out from the economy, it will adversely impact India’s growth rate and also adversely impact specific areas of the economy such as the real estate sector and the transport sector, which has a direct impact on all sorts of other sectors. Estimates range from 1 to 3 percentage point loss in annual GDP growth as a result of this move. How bad it actually will be depends on how quickly the govt. replenish cash in the economy. Although, I am not quite sure they want to completely replenish cash, as that would defeat one of the major purposes of this move.

In conclusion, I’d steer clear of any superlatives to describe this move. It is neither a masterstroke or a monumental mistake. It certainly is brave and one that evinces political courage and honesty. Such moves can only be done once in a few decades, and are in comparison to other options, easier to plan and implement. The real test will lie in the follow up action Modi initiates to complement this massive exercise. Reforms in political funding, direct and indirect tax collection, stock market (participatory notes), and land will start to yield results that will justify the trouble this move has caused. Whether this will be the case remain to be seen.


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