De-monetisation update 6: the economic costs and much else

With the end of the first week of the announcement of the Prime Minister on the demonetisation of old 500 and 1000 rupee notes approaching, it is clear that the logistics of the announcement are not going as well as they should have. That is putting it mildly, perhaps.

As for the underlying need for the measure that the Prime Minister had announced a week ago, I am not in doubt. Some have expressed scepticism whether the 500-rupee note should have been demonetised at all. It might be mostly for transactional purposes rather than being used as a store of wealth. Hence, banning it too has been a source of  great inconvenience without being a great source of benefit. The rich will find a way to convert their currency notes even if not through the banking channel, etc. etc.

I will share links to some comments by people whose views I do not disregard:

MINT wrote a good editorial on this:

It is widely accepted that Modi has strangled corruption at the highest levels of government. The currency swap should hurt those who have been involved in retail corruption. Other policy initiatives such as the move to GST should also bring more producers into the indirect tax net.

Modi has perhaps understood the aspirations of his new voter base better than most people realize.

The Edit also made an important point for the future:

RBI should now consider switching the composition of currency towards Rs100 notes rather than Rs500, Rs1,000 and the new Rs2,000 ones. In other words, a majority of the value of cash in the Indian economy should be accounted for by Rs100 notes, backed by a greater use of mobile payments to avoid unnecessarily bulky wallets.

The speech by the Prime Minister contained a reference to that and that is the direction in which RBI and the government would go.

I would like to reserve Monika Halan’s piece for the end for it touches upon a very important aspect of this decision – the Prime Minister’s risk-taking.

There was a good piece by Shankkar Aiyar in ‘New Indpress’:

This week the government took another shot at tackling the twin devils by demonetising high value currency. Critics observed that this is a redux – it has been done before. True. But the difference is the scale. The first demonetisation of 1946 resulted in the demonetisation of Rupees 143 crore out of Rupees 1,235 crore currency with the public. In 1978, the Morarji Desai regime demonetised Rupees 146 crore out of Rupees 9,152 crore. In 2016, the Modi Sarkar has demonetised Rupees 14.95 lakh crore out of Rupees 16.98 lakh crore.

Step away from the numbers to appreciate magnitude in words. In 1978, the quantum of high denomination notes demonetised was barely one in hundred, or 1.52 per cent notes with the public. In 2016, high denomination notes demonetised account over eight of 10 notes in circulation. The validation of the scale of the action is visible in the untold disruption in the economy.

He understands and states that there is lot more to be done:

The war on corruption and black money calls for holistic action. It is a hard road. To paraphrase General Patton, the exhilaration of victory, demands acceptance of challenges.

He concedes the exhilaration of victory but a lot more remains to be done. In our joint piece for MINT today, Gulzar Natarajan and I agree with that and even list out the things that need to be done. We have gone into specifics. It is from our joint work, ‘Can India grow?’ which will be published online by Carnegie India tomorrow.

So, the case for the action taken is established and the action is to be applauded. But, the action’s positive impact will be felt over the long-term provided follow-up actions and steps are also announced. However, in the near-term, the logistics of implementation are creating a big economic dislocation risk, or so it appears.

Given the ‘surprise’ nature of the announcement, the scale of the country (huge ) and State capability (very low), some amount of dislocation was to be expected. The public was prepared for it. But, has the actual dislocation exceeded even the worst expectations?

Pronab Sen seems to think so. He points to the dislocation in the informal financial sector:

There is, however, one component of the economy that may actually experience a permanent effect—the informal financial sector. This sector, comprising not only the much-reviled moneylender but numerous other institutions such as nidhis, hundis, chit funds, etc., will have a very hard time exchanging its stock of currency (some of which may well be black money), and may indeed suffer a permanent erosion in its lending capacity. We might not shed any tears for them, but spare a thought for those whose livelihood depends on the capital provided by this sector because the formal financial sector will never touch them with a barge-pole.

How large is this problem? I had made a rough estimation of this during the preparation of the 12th Five-Year Plan, and it came to nearly 40% of formal bank lending—i.e. 26% of GDP—which is not a joke. [Link]

He calls this exercise the equivalent of cutting the nose to spite the face. That is perhaps too harsh. The government has been taking a sequence of steps. This has to be seen as part of it and more must be coming. There has been a method to the issue of tackling the issue of corruption. Mr. Sen is very right to highlight the area where the move would hurt.

Indeed, economic growth is being driven by private consumption in India, in recent times. If parts of it are choked too hard, the negative demand shock on the economy could be significant. Already, there is the negative wealth shock to those who are spending their black money. Third, there is the impending introduction of GST. So, I think the government might have bitten off more than it could chew, from a macro-economic perspective.That strikes me as a more appropriate idiom than ‘cutting the nose to spite the face’.

A friend with whom I had shared this article sent me the following response:

The informal sector will bear the brunt. Even today Meera Sanyal narrated how in the Pushkar festival there are no buyers. This is a typical market where purchases take place with cash. I know from my sources in the rural areas that the informal sector there is collapsing. The depth of our current formal financial system in regard to informal sector is poor. So replacement will be very tardy.

Current rules will render the use of unconventional processes for replacement of currency notes to the informal sector impossible. I guess these enterprises will die and for them subsequently to get capital to restart will  be next to impossibility since the chain will be cut off. And these people are the consumers of the big firms, who will find consumption from the rural areas from now on not helping their topline. As economists say, this step is a supply shock which will lead to demand shock. I am wondering if I am too pessimistic.

Perhaps, he is and perhaps he is not. But, the risk is no longer trivial or so, it appears. MINT has three charts on why the exercise is turning out to be painful. The government must start its prayers now!

That brings up a question that another friend asked:

Can you help think through this standard argument that his could have ONLY been done in a shock and awe manner? What if it had been announced that by Dec 31st all 1000 rupee notes will be retired. anyone that is bringing a note to deposit or exchange to the bank will need to account for it.
 A former bureaucrat gave a very thoughtful response (paraphrased):
1. Have extensive stakeholder consultations, prepare a comprehensive plan covering all dimensions, elaborate to the last detail, and then roll-out the reforms in a predictable environment.
2. Identify an important element of the reform process (based on political and administrative expediencies) and bite the bullet. Hope that it would generate the momentum for change (create conditions, ripen the moment for wholesale change). Intervene strategically and opportunistically with all the other elements of the comprehensive plan in due course.
The first is a linear and logical approach, whereas the second is by definition non-linear and iterative. On deep-seated changes, the former would most likely overwhelm the political and bureaucratic systems (albeit for different but very compelling reasons) and lead to a decision paralysis. It’s just that there are too many bells and whistles associated with such comprehensive plans that they are most likely to run into the constraints of political acceptability, financial and other resources, administrative capacity, and mobilisation of entrenched interests.
In the circumstances, I feel that a more prudent approach would be to identify a totemic element of the implementation plan that can rally the troops, wait for an opportunistic political moment, intervene in a manner that it creates a momentum, and then chip in with all the other elements of the plan.The risk with the latter approach is that the government identifies the wrong elements, intervenes at the wrong time, and fails to follow up with other elements.
The demonetisation may have done all the first three elements of this second approach, and now awaits the other parts of the comprehensive plan. Given the rising discontent, it may be necessary to unveil all the other elements without waiting too long.

I would add more element to the response. If the secrecy were to be abandoned and people given sufficient time to do so, the change of behaviour from cash-reliance to banking channels might not happen. The public would find a way to exchange their old currency notes and continue with the cash economy. In this ‘shock’ therapy, there is a reasonable chance of changing behaviour in the right direction. That is the ‘signalling’ value of this the ‘shock’. Of course, the evidence has to come from the future.

Also, see Tamal’s defence of the ‘secrecy’, ‘shock and awe’ in his superb piece in MINT:

However, could this chaos have been avoided entirely? Certainly not. Secrecy is the key to the success of such a move. There was only a three-hour window and even that was wide enough for many with unaccounted money—they bought gold and foreign currency till the wee hours of 8 November, paying as much as 50% premium. Had the government and the Reserve Bank of India (RBI) wanted a foolproof transition by stacking currency chests of all banks with new notes to ensure a smooth transition, the black money hoarders would have got wind and the very purpose of this exercise would have been defeated.

The choice before the government was to announce it out of the blue and run the risk of the chaos on streets or have a smooth transition from the old currency notes to new notes but without getting much out of it in terms of unearthing unaccounted cash. It has chosen the first, and rightly so. My understanding is that the plan was to launch this a bit later, probably in January, but the image of the new Rs2,000 note making the rounds in social media last week unnerved the government and it did not want to take chances with the plan being leaked and instead preferred to launch it immediately, even though the printing of Rs500 currency notes had not even started at that time.

As we have come to expect of Tamal Bandyopadhyay, his is a stellar piece. I conclude this blog post with that.

That brings us to the final element of this blog post. There is both an upside and a downside to the concentration of this initiative in the Prime Minister’ office and with the Prime Minister. “The risk of the discontent – when things go wrong – being concentrated at the top is very high” (quote unattributed).

In this particular demonetisation exercise, may be, there was a case for secrecy and for concentration of decision in few hands. But, if all decisions pertaining to all Ministries are seen as being made only in the PMO, the risk is very high. It is also undesirable at many levels. Sharing responsibility and credit are as important as making decisions, taking risk and taking credit for them.

As Monika Halan writes, the Prime Minister has taken a personal and political risk here. Indeed, given the plausible economic growth shock, the risk is enormous:

It’s not as if Prime Minister Narendra Modi has not taken a risk—both personal and political. The move to demonetise currency notes, to suck out black money, will upset BJP’s key constituency: traders, realtors and small businessmen…. So the risk is real.
Her conclusion is something which this blogger very wholeheartedly and enthusiastically endorses:
Modi has taken a calculated gamble and we’re all hoping that it pays off. No transition is painless. He is pressing the reset button on corruption. We, who had so desperately wanted to kill corruption, now need to support this bold move by the government.
Back to Tamal:
Indeed, this drive will attack the stock of black money and not the flow, but it will instil the fear of god in the tax evaders the way the new insolvency law will psych the wilful defaulters of the banking industry….
This is the signalling value of the shock that I had mentioned earlier.

… The immediate challenge before the government and the RBI is to meet the demand for currency. The jute and tea industries in West Bengal have come to a grinding halt; India’s Rs64,000 crore microfinance industry has virtually stopped disbursement of fresh loans and there is pressure on collection of loan instalments; lakhs of people are losing their daily wages as they need to spend hours outside their banks to deposit and withdraw money. All these may lead to social unrest and deteriorating law and order situation in various parts of the country.

The cascading effect of the move can outweigh the gains if not handled properly. Mere congratulations to 1.25 billion Indians and appeal to their patience will not work. Modi may have more plans up his sleeve to fight black money but at the moment, the buck stops with the prime minister.

Yes, if handled properly and followed up, it could be a lasting legacy of the government. Indeed, the issue has thrown up the stark challenges that India faces on the State capability front. The implementation of GST lurks from the next financial year. In an indirect way, it has become a curtain raiser or trial run for it. So far, the State has come up short. If it leads to some material changes in the State capability, its organisation and the incentives for performance, so much the better. The collateral benefit of improved state capability could be far more substantial than even the benefits on the corruption front.

This and the GST implementation can become seminal case studies on many aspects of governance: changing culture, behaviour, nudge, implementation, project management, state capability improvement and indeed, refashioning the economy, the government and much else.


2 thoughts on “De-monetisation update 6: the economic costs and much else

  1. I don’t think 2nd order aspects have been considered well enough. People are hoarding 100 rupee notes. Maybe as soon as the new 500 rupee notes start circulating we will see things even out.

    But there is a huge unaccounted black economy in every aspect. Example: The auto rickshaw drivers in Bangalore earn enough to be in the taxable bracket. And the scale of evasion is just so big.

    I simply think that getting income taxes in India is difficult. Consumption and wealth taxes though maybe more regressive could be better.


  2. Somehow, most of the commentators, including few of them you credited, are either writing about the short term/current impact (How common people suffering for currency etc) or the Long term consequence (How the economy might get benefited with the inclusion of 70% of cash into system etc etc). What is missing in my opinion is the medium term outlook and what steps need to be taken to ensure economy wont swing into negative. Your thoughtful, balanced and well referenced post, makes references to this crucial problem. I wish we also could see few recommendations to Government, which appears to be alarmingly silent on this front (in communicating or in taking actions to handle this impact)

    I am worried that the multiplier effect, as referred by your friend is already in action. People are hoarding their limited cash holdings resulting in crash of sales everywhere. This affects lot of retailers and small businesses. It further affects demand for purchase of goods in the wholesale markets; and so on.
    If this continues, by the end of this month and by December, several businesses will find tough to pay salaries, thus by making the situation much worse. Today there is a news that Telangana state govt’s finances are so severely hit that it is mulling to cut pay to employees by half till the treasury collections improve. If this is the situation of state finances, how can small businesses work?

    It appears there is no collective, collaborative decision making. Center should reach out to all stakeholders. States have a major role to play in impacting the daily lives of people and concerted steps (BY Center + state) are need of the hour. For example, real estate. We know that the value of an real estate asset is derived from payment in Cash + Cheque. Now that there is no Cash component, is there any advisory on how the properties can be traded or sold? Or is it left to the people and market to arrive and adjust for the new values/rates? Cant Center govt work with state governments and find a way to bring some confidence in the markets? (Increasing the Govt Value of the property, lowering the registration taxes etc)

    If India needs to see a real benefit from this move, a lot needs to be done by the Government.

    Liked by 1 person

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