If you are in India right now and have 1500 bucks in local currency in your wallet, you could still have no money at all depending on in what denomination those 1500 bucks are in your wallet. Ladies and Gentlemen, introducing to you the second trending google search term within a month in India after “surgical strike” and the phenomenon this time is called “Demonetization”. On the evening of November 8 Indian Prime Minister Mr. Narendra Modi sent shockwaves through the length and breadth of this country by announcing that Rs 1000 and Rs 500 notes would stop being legal currencies from midnight, thus absolving RBI of its promise to pay Rs 1000/500 to the bearer of those respective notes. The decision wiped out 86.4% of the currency in circulation (amounting to a total value of Rs 14,180 billion) at one go with a three-fold objective:
- Fighting black money accumulated in the form of cash
- Getting rid of fake currency circulating in the system
- Plugging terror funding using cash of higher denomination
The government set a 50 days deadline (until 31st December) to get the currencies either exchanged or deposited with withdrawal/ exchange limits in place throughout this period of scarcity. New Rs 2000/500 notes have been introduced to replace the old notes. It is a move that has probably affected each and every individual of a primarily cash economy. The consequences are quite apparent with long queues in front of ATMs where people frantically wait to get their hands upon their quota of cash to meet their basic day to day demands. The affects are also all over the media, with stories running about the deaths of about 70-80 people while waiting in queues or suicide due to depression resulting from lack of cash.
The jury again is divided about the promised effectiveness of this move to meet its 3 fold objective. On one side are the people supporting the move as first real step against corruption in the 69 years after independence with a short term pain and long term gain. On the other are people calling it one of the biggest blunders, which will derail a cruising economy with negligible firepower against corruption and black money. I am afraid, in this particular case, I am a skeptic on the opposite side of the establishment for very logical reasons as I perceive them. One by one I will dwell upon my reservations with the move but first I will give a background of role of cash in Indian economy.
As per a BIS 2011 data, India is the 4th most cash dependent economy measured in terms of cash to GDP ratio after Japan, Hong Kong and Russia. Thus cash is very central to Indian economy, especially in the lower rungs of Indian population where the bank, mobile and internet penetration is still very limited. Money is very essential in any economy in the sense that it is a medium of transaction for any product or service created in the economy and thus creates income, contributing to GDP. In fact the relationship between GDP and money can also be established as:
GDP = Money Supply in the economy * velocity of money in the economy, where velocity of money is the number of times money is circulated in the economy per unit time
Thus, given that a large volume of monetary transaction in the Indian economy takes place in the form of cash, cash becomes a big contributor to income generation/ GDP especially in the lesser developed areas.
The numero uno reason for this move by the present government (aka Mr Modi) have been the devils of black money and corruption that have haunted India since independence. Black money is the unaccounted money against which taxes have not been paid and is thus a loss for government as well as an unrecognized national income. This economy is thus also called shadow/parallel economy, since it is not contributing to the official GDP number.
Black money is hoarded mainly in 3 forms: in the foreign bank accounts in safe havens like Switzerland, invested in real estate or commodities like gold and stored in the form of cash. The present move by the government has been to fight the third medium of black money hoarding. This is the most contentious issue on this move. According to Professor Arun Kumar, a retired JNU professor in economics who has been studying black money in India his entire academic career, black wealth amounts to about 300 lakh crore of the Indian economy, of which only 1% i.e. 3 lakh crore is in the form of cash. This move, given the scale of execution that is required and the amount of inconvenience it is already causing, does not justify the “peanut problem” it is trying to solve.
The inconvenience that we are talking about is not only in the form of ATM or Bank queues, that is the kind of inconvenience that only middle class in India sees who have the luxury of using plastic money in lieu of paper cash. The real inconvenience is due to the disruption that it has caused in the lower strata of society. As already mentioned, it is this strata which is the most dependent on cash transactions in India. Most of the agricultural earnings and wages are in the form of cash in the villages. The small enterprises like local kirana shops (small brick and mortar shops) and other service providers are also dependent on cash payments. Also worth mentioning is that their daily earnings are not very high, and the cash is the only source for these small businessmen to invest as working capital in their businesses, so even a small disruption in cash earnings can lead to many businesses being made nonviable.
Apart from all the inconvenience being caused, the logic of the move itself is questionable. The government is replacing the 500 and 1000 notes with new 500 and 2000 notes. It will surely disrupt the current black money market and control corruption temporarily but there is no guarantee that the same level of corruption and black money equilibrium will not be reached using the newer currency. This move can only work if either or both of the following two statements are true:
- this move disrupts the payment medium in India in favor of cashless digital transactions with plausible audit trails
- demonetization is a credible threat, and thus discourages people from stashing illegal cash in the fear of another demonetization
I do not see the first point being successful since the newer 500 and 2000 currencies are going to replace the older 500 and 1000 notes and they are going to be replaced within months. Such a payment disruption will require both technological and behavioral progress at an unprecedented scale in a country like India. The time period between the older equilibrium and the expected newer equilibrium is not long enough for this kind of progress. People are currently very comfortable with cash transaction and thus it will take time for the people to get comfortable with newer means of transaction on a large enough scale, especially the small merchants and rural consumers will find it very difficult since the mental block is accentuated by technological reach.
My concern with the second argument can be understood by using the following matrix (a game theoretical approach):
|Do not demonetize|
|Hoarders||Hoard||1,0 (Nash Equilibrium)||-1,0|
Now, the government has two decisions to make in the foreseeable future, demonetize the new currency again or not do it. Similarly, the black money hoarders have two decisions to hoard or not to hoard. I have represented the pay offs for each decision combination with -1,0 and 1 where 1>0>-1. The payoffs are separated by commas with the first term representing payoff to the hoarders and the second representing payoff to the government. Given the kind of backlash government has had to face after the current demonetization decision, it is obvious that not demonetizing will be a better decision in case hoarders decide not to hoard, and the payoff of two can be assumed to be almost equal in case hoarders decide to hoard and thus the decision “do not demonetize” is weakly dominating decision of demonetization. Now, in the second iterative step, the decision to hoard is dominating decision to not hoard. Thus by iterative elimination, “Do not demonetize and hoard” cell is the weak Nash equilibrium, which rubbishes the second argument here.
In my opinion, bringing the shadow economy to the mainstream is not an objective that is achievable through this move. Thus projecting it as a move with long term gain is very questionable. On the other hand, projecting it as a short term pain is also not correct. It might be a short term pain for people whose only concern is standing in ATM queues and who have the luxury of using debit/credit card for most of their transactions. The most affected people lie outside this realm, they are the people who subsist at the bottom of pyramid with very limited access to banking and technology, in the modern usage the people who exist outside the ‘www’ network. As discussed earlier, for very obvious reasons, businesses are shutting down, credit has dried up and there are people who have even lost their lives. The effect on GDP will be anybody’s guess right now with a negative trend in most sectors, the extent and longevity of which only time will tell.
Another institution which has been very adversely affected since this move, is RBI in terms of its credibility. RBI is an institution which relies on its credibility for its policies to be effective, which is very much dependent upon expectations. These days if you are following the RBI website regularly, one constant notification you see is regarding the updation of the demonetization FAQs section or any new communication regarding the change in rules. This iterative approach of ad hoc problem solving puts the credibility of RBI under question, especially at a time when there has been a change at its helm and Urjit Patel has taken over from a popular Raghuram Rajan. This does not augur well to an institution of the caliber of RBI which has until today remained a lone institution with unquestionable integrity and reputation in a country infested with corruption at the institutional level.
On the last two objectives of this move (fake currency and terror funding which are very much related), again the disruption may be very temporary depending on the quality of safety features in place on the new currencies to curb imitation. The effectiveness of demonetization on these two fronts can only be realized with time, in lieu of any solid data on the same.
Thus, overall although I would love to see the move working wonders on cleansing and catapulting Indian economy, I am also very skeptic on the effectiveness of this move. I would love to be proven wrong though.
Long live democracy!
PS: A huff post collation of deaths due to demonetization (reported across sections of media): http://www.huffingtonpost.in/2016/11/17/day-9-demonetisation-death-toll-rises-to-55/