Demonetisation update 22 – sequencing economic disruption

This is an expanded version of my column in MINT today:

According to some well-informed observers, the Prime Minister of India is apparently quite frustrated at the pace (or, the lack thereof) of change that he is able to effect in India. That is understandable. First, a combined opposition put paid to the hopes of reforming the land acquisition laws that the previous government had put in place. Then, changes to the appointment of judges passed by both the houses of Parliament and approved by States was rejected by the Supreme Court. In recent years, the Court has interjected itself in matters ranging from cricket to jallikattu to the use of Aadhaar for direct benefit transfer to the national anthem. Naively, we used to think that power, its arbitrary application and lack of accountability were usually associated with the political class.  Then, on November 8, he came up with an unprecedented announcement. He felt that he had outsmarted fellow politicians and bureaucrats.

He had failed to reckon with the banking sector of which his government is the shareholder. Banks had preferred to distribute cash through branches rather than through their Automatic Teller Machines (ATM). Based on the search and seizure of new bank notes in crores from the homes of bureaucrats and the well connected, now we know why. He has now announced that the government would pass the budget for 2017-18 on Feb. 1. But, the Election Commission has announced the schedule for elections to five states starting within three days of the budget presentation. If the government were to be prevented from presenting a proper budget, then whatever little chance of stimulating the economy through public spending to compensate for the impact of the monetary shock on economic growth would be gone.

The Central Statistical Organisation has put out an estimate of growth for the year ending March 2017 based on just seven months of data. Given that it does not have a clue – no one has – as to what has happened to the economy since November 8, this estimate is, for all practical purposes, useless.

So, while the frustration is justified, there is only that much one can pin on external forces and factors. But, in the real world, one has to play with the cards one has been dealt. The announcement of November 8 had a morality component and an economic component. Many black money holders appear determined to ignore the morality aspect, going by the unofficial estimates of cash that has entered the banking system. While it does not amount to a failure of the currency swap initiative, it will be disappointing to the government. In theory, taxes can be collected on the money deposited. In practice, how much the government will collect and how much the taxmen will take is a matter of conjecture. Then, there are egos, power plays and silos. Neelkanth Mishra of Credit Suisse was shocked to note that there was limited information sharing between the Central Board of Direct Taxes and the Central Board of Excise and Customs. They both signed a Memorandum of Understanding (MoU) to share data. Yes, two departments under the same Ministry had to sign a MoU to share data.

Going by his speech of Dec. 31, the Prime Minister has done well to recognise that the morality dimension is incomplete without the political system playing its part. But, intentions are one thing and delivery is another. How far his own party is willing to go along with him on this aspect is a matter of speculation.

As for the economic component of formalising the informal part of the economy (it is also a part of the black economy and not just corrupt transactions), there is no global precedence to achieve it in this manner. Some portions of the informal economy will be extinguished. Some will be able to make the transition to the formal economy. It depends on financial resources, enterprise and skills. Equally important is the ability of the formal sector to absorb them, to create scale and jobs. The formal sector is in a state of funk. It is still grappling with balance sheet issues. Banks are not lending. The mere fact that there is money within the banking system would not lead to more loans without resolution of the legacy issues of non-performing loans and recapitalisation of banks. With the exit of Raghuram Rajan, the issue of non-performing assets in the banking system has also been quietly buried. Whatever happened to Indradhanush? Did the arrows ever leave the quiver? Fixing the banking system by jettisoning the existing shareholding patterns should have preceded the currency swap for the latter to be effective.

It is quite possible that the manner in which Raghuram Rajan had been ousted has come back to haunt the government. For one, all the allegations thrown at him by leaders belonging to the ruling party have quietly been buried. Two, the exercise sent a clear message to his successor as to what the consequences would be if he were to act independently. Whether this influenced the advice (or, the lack of it) that the government received from the Reserve Bank of India on the currency swap exercise is another matter for speculation. But, that a former Deputy Governor of the central bank took to a public forum to express her anguish at the conduct of her former employer is an indication of the observed communication and competence deficit.

The Prime Minister has a few decisions to make in the New Year. If he is determined to disrupt and if incrementalism is deemed inadequate for India’s development tasks – he has to disrupt the banking system and the tax system. GST introduction and the technology aspects associated with it have to be better managed than the currency swap exercise. Drastic overhaul of direct taxes – rates, thresholds and exemptions – are drastically overdue.

Learning from the lessons of the relationship between UPA and the National Advisory Council that existed then, the Prime Minister has to strike a better balance between competence and loyalty in terms of advice. Mistrust and personal insecurity result in a higher weight for loyalty over competence. Finally, I shall repeat the point I made at a gathering at 7 Race Course Road in September 2015: if the Prime Minister governed as though he had only one term in office, he stood a far better chance of having a second shot at office in 2019.

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