A HIGH-STAKES GAMBLE

By suddenly changing India’s banknotes, Prime Minister Narendra Modi caused huge disruption, but is calculating that the political benefits will make it worthwhile, writes AK Bhattacharya

India’s Prime Minister, Narendra Modi,has taken his biggest and boldest economic policy gamble by far. In a televised address to the nation on November 8, he declared that high-denomination currency notes of Rs 500 and Rs 1,000 (equivalent to less than US$8 and $15 respectively, at current exchange rates) would cease to be legal tender from midnight.

The central government listed three primary reasons – an assault on ‘black money’ gained by corruption, rooting out fake currency, and preventing the financing of terrorism, using high-denomination notes. But the disruption that resulted caused many to ask whether the shock treatment was worse than the ailment.

Make no mistake about the enormity of the decision. At a stroke, demonetisation flushed out almost 86 per cent of the currency in circulation. For a country where cash is nearly 12 per cent of gross domestic product (GDP), and accounts for almost 90 per cent of all commercial transactions, the decision was sure to have a huge ripple effect on the economy. But the government went ahead with the experiment, despite short-term dislocation and vast inconvenience to millions of people.

CASH FLOW PROBLEM: India’s sudden demonetisation has caused long queues at bank branches
CASH FLOW PROBLEM: India’s sudden demonetisation has caused long queues at bank branches

The decision-making process was understandably shrouded in secrecy. It has been reported that only a handful of people knew of the decision in advance. The Prime Minister’s address to the nation was recorded in utmost secrecy just before the Cabinet met. Ministers were required to enter the meeting room without their mobile phones, andsome were prevented from leaving the room until Modi’s address had been broadcast. So stunned were they that not much discussion was reported to have taken place.

demonitisation 2000 note

There was similar dismay among those charged with the execution of the scheme.Though up to 250 million new bank accounts have been opened in the last couple of years, banking penetration in India is among the world’slowest, with nine branches per 100,000 persons and fewer than 40 branches per 1,000 square kilometres. The numbers for rural India are even worse. The country has over 200,000 automated teller machines (ATMs), most in big cities and towns, butall had to be recalibrated to dispense new notes – an exercise expected to take at least three weeks.

Other numbers were even more daunting – there were about 23 billion currency notes with denominations of Rs 500 and Rs 1,000 that the government had to replace quickly. This was too much for the four domestic printing presses to achieve without a long delay, but importing currency at short notice was not feasible, and posed possible problems of security.

Apart from the assault on black money, demonetisation was also intended to eliminate fake currency from the system, but according to one think tank, this is not a big problem. It estimated that counterfeit money in circulation could add up to as little as Rs 4 billion. As a former deputy governor of the Indian central bank pointed out, you do not reject an entire bag of rice if it has some stones – you simply weed them out from the rice, rather than declaring the whole bag unusable.

The huge inconvenience caused by the sudden change, in particular to poorer sections of society, was evident in long queues and overcrowded bank branches. Rules had to be relaxed to allow the use of old currency notes in public utilities such as petrol pumps, government hospitals, chemist shops, milk suppliers and later for mobile connections. After an initially slow response, the crisis eased in urban India, where queues were shorter and many ATMs began dispensing new currency notes.

Within days the government began arguing that demonetisation was an attempt to move India toward a cashless economy – a highly ambitious task, though electronic payment companies reacted quickly and took some of the pain out of the adjustment for urban Indians. Digital India, a government scheme to promote the use of information technology for delivery of services to people, is now being used to push much of the cash economy into digital transactions.

But the worst difficulties were faced by farmers, traders and small businesses. With the next sowing season having arrived, farmers were frantically looking for cash to buy seeds and fertilisers. The government response was partial, allowing state-owned seeds companies to accept old currency notes from farmers. Many small businesses simply decided to close their doors until the situation stabilised. Some traders quickly improvised, managing to accept electronic payments, but many found the shift too sudden, cumbersome and painful. Ironically, what was being touted as a digitisation drive led to the deepening of the digital divide in the country.

It would be naïve to believe that there was no political motive behind demonetisation. Not coincidentally, the Modi government is more than half-way through its five-year tenure. The Prime Minister realises that development and jobs are promises that may not be fulfilled soon: benefits from such projects accrue over a longer period, and the global economy is in turmoil. In contrast,a highly visible attack on corruption has a political impact unmatched by other initiatives.

Though the government faced many questions over the abrupt manner in which it carried out demonetisation, a large section of ordinary Indians appears to have accepted that it will target ‘black money’, and particularly thewealthy and corrupt people who hoard it. As the country prepares for as many as five state assembly elections in 2017, it could change the popular narrative from the many pains caused by inflation, slow economic growth and tough reforms, like the introduction of a goods and services tax.

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Consider also the fact that most of India’s electoral funding by political parties is in cash. Not only has the demonetisation drive deprived many parties of the ability to use the money they have accumulated, Modi’s political opponents would have a hard time challenging a crackdown on corruption and terrorism, even though there is clear evidence that only a small part of India’s black economy (estimated at around 23 per cent of GDP) is in cash. The bulk is in activities that are not taxed, such as gold trading, construction and land deals. India’s tax rates and tax administration have improved, but continue to deter people from bringing all their transactions above board.

Some of the worst difficulties are faced by farmers, who fear missing out of sowing time
Some of the worst difficulties are faced by farmers, who fear missing out of sowing time

The gains from demonetisation, therefore, remain unclear. Many Indians were reported to have gamed the system – depositing their cash through intermediaries, or using the accounts of poor people under the Jan Dhan Yojana scheme, where deposits rose by almost half after demonetisation. The government said the impact on GDP in the medium to long term would be positive, but did not deny that economic growth in the short term would be hit.

If the Modi government wants to stamp out corruption completely, it will have to go considerably further. Reforms in election funding would be needed, bringing political parties under transparency laws like the Right To Information Act. Other measures would include fixing the loopholes in the benami property laws (which define a transaction in which the official owner of the property is not the real beneficiary), and changing real estate pricing rules and the stamp duty regime. Since ‘black money’ in India is largely hoarded in the form of gold and silver, disclosure of such holdingsshould be forced.

These are all big steps, perhaps bolder than demonetisation. But if Modi does not muster the political courage to take them, printing new Rs 500 and Rs 2,000 notes may achieve only half the desired outcome.


The author was Editor of Business Standard from 2011 to 2016 and of The Pioneer from 1995 to 1996.Now Editorial Director of Business Standard,he writes two fortnightly columns on government affairs (Raisina Hill) and economic policy (New Delhi Diary). He can be contacted at ashok.bhattacharya@bsmail.in

 

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