WORTH IT?

Bewildering pain and desperate hope mark two months of demonetisation in India

Obsession
Future of Finance
Quartz india
Obsession
Future of Finance
Quartz india

It’s been a testing two months for Indians.

Forced into long queues at ATMs and banks since Nov. 08, when Narendra Modi invalidated 86% of the country’s cash in circulation, the past two months have been nothing short of a nightmare for the country. Yet, most have braved the inconveniences for the larger good that the Indian prime minister has promised through demonetisation: curbing terror funding, counterfeit currency, and unaccounted wealth worth a staggering 20% of India’s GDP.

“The 500 and 1,000-rupee notes hoarded by anti-national and anti-social elements will become just worthless pieces of paper,” Modi had said on Nov. 08. He then sought a 50-day period until the end of December to fix all the troubles caused by demonetisation.

Now, two months later, Modi believes his big gamble has paid off.

“History is witness that the Indian banking system has never received such a large amount of money in such a short time,” the Indian prime minister said in a much-anticipated televised speech on New Year’s eve. Until Dec. 13, some Rs12.44 lakh crore, or 80% of the Rs15.44 lakh crore in Rs500 and Rs1,000 notes in circulation before demonetisation, had been deposited in bank accounts across the country.

Meanwhile, it hasn’t been a smooth ride for Modi either. His government has faced serious embarrassment over the many policy flip-flops and lack of preparation vis-a-vis demonetisation. For instance, some reports said the Reserve Bank of India (RBI) did not even have a single new Rs500 note ready on the day the mammoth exercise was announced.

“We took the demonetisation decision not for some short-term windfall gain, but for a long-term structural transformation,” Modi said on Dec. 29. “The multiplier effect of introduction of money which was, till now, uselessly hoarded and stocked away as cash, into the active economic system will give the economy a further boost,” he said in an interview to the India Today magazine.

Here’s looking at the course charted by the most disruptive reform measure undertaken by the Modi regime.

Chaos and deaths

Undoubtedly, demonetisation brought chaos in its wake.

People had to queue up for hours to either withdraw the new currency notes or deposit the now-illegal old ones. By Dec. 08, that is one month since Modi’s announcement, 100 people had already died reportedly due to causes directly or indirectly related to demonetisation. This included overworked bank officials. While many died due to the physical stress of spending long hours in serpentine queues, some were driven to suicide out of desperation.

The shortage of new notes led to an acute liquidity crunch in the economy, forcing many to hold off discretionary expenditure. Many weddings, for instance, were postponed as families did not have enough cash.

In short, the government stumbled when it came to execution. Add to that the incessant tweakings.

All about flip-flops

The Modi government has come under fire for the many flip-flops. For instance, it had said on Nov. 08 that the exchange of old notes worth up to Rs4,000 would be allowed at banks and RBI counters till Dec. 30, 2016 (pdf). By Nov. 24, however, the exchange facility at banks had been discontinued.

It also dilly-dallied with the daily exchange limits; first set at Rs4,000, it was reduced to Rs2,000 within 10 days.

Here is a list of the major events of the demonetisation months, including some of the flip-flops:

Date What happened
Nov.08 Modi declares the Rs500 and Rs1,000 notes invalid. Exchange of currency up to Rs4,000 allowed at banks, ATM withdrawal limit set at Rs2,000.
Nov.10 Banks reopen after a day. Massive queues ensue as millions line up to deposit or exchange old currency.
Nov.12 Deaths attributed to waiting in queues begin to be reported. The Sensex registers the biggest single-day fall in nine months.
Nov.13 Currency exchange limit raised to Rs4,500 and ATM withdrawal to Rs2,500.
Nov.15 Banks asked to use indelible ink marks on those exchanging money, election commission raises concerns.
Nov.16 Parliament session begins; opposition parties corner the government over the sufferings of the poor.
Nov.17 Currency exchange limit lowered to Rs2,000.
Nov.18 India’s supreme court says many are “frantic” over demonetisation.
Nov.22 RBI says banks have received Rs5.3 lakh crore in deposits since Nov. 08.
Nov.24 Old notes can now only be deposited at banks and not exchanged.
Nov.27 RBI governor Urjit Patel justifies demonetisation, says the new notes are difficult to counterfeit.
Nov.30 RBI limits the withdrawals from Jan Dhan accounts to Rs10,000 per month.
Dec.08 The Modi government announces incentives to initiate people into digital payments. Offers dicounts on digital payments.
Dec.19 The RBI says deposits above Rs5,000 in old currency to be permitted only once until Dec. 30, the last date for depositing old notes.
Dec.21 The RBI withdraws the restrictions on depositing cash above Rs5,000. Allows multiple transactions until Dec. 30 provided they are know your customer-compliant
Dec.31 Narendra Modi thanks Indians while addressing the nation on new year’s eve. Says “firm resolve” and “infinite patience” characterises 125 million Indians.

Meanwhile, the government’s stated objective changed. In the past few weeks, rather than harping on the curbing of black money, it has increasingly used demonetisation to push India towards becoming a cashless economy. Asia’s third-largest economy has one of the world’s highest cash-to-GDP ratios—nearly 12% compared to around 3.9% in Brazil and 3.7% in South Africa.

On Dec. 08, the Modi government offered a slew of incentives to push Indians towards digital payments. This included discounts on the purchase of fuel, railway tickets, and insurance policies. It later launched the Bharat Interface for Money (BHIM) app for “fast, secure and reliable” cashless payments.

“It’s a part of our campaign to incentivise people, to persuade people,” Arun Jaitley, India’s finance minister, said during a press conference. “I think incentivising people to go digital and shed cash, to the extent it is possible, is a good development for the economy.”

Impact on economy

Consumer demand, for one, has taken a hit.

Fast-moving consumer goods (FMCG) firms have reported lower sales, especially in rural areas. Some 90% of the FMCG market in India comprises small mom-and-pop stores, heavily reliant on cash sales. And 60% of small traders have already seen a drop in sales post-demonetisation, according to market research firm Nielsen.

In rural areas, where internet penetration is limited, cash is often the only mode of payment. People in the hinterlands have struggled to access cash—there are 7.8 bank branches per 100,000 persons in rural India—and this, in turn, has affected wage and loan disbursal in these areas.

Besides microeconomic headwinds, the overall Indian economy, too, has seen some effects. GDP growth in the world’s fastest-growing major economy is estimated to take a hit in the coming quarters. Most analysts, apart from the RBI itself, have revised their GDP estimates. The Indian central bank, too, has lowered its forecast for 2017 by 0.5% to 7.1%.

In fact, brokerage Ambit Capital slashed its estimate for India’s GDP growth to just 3.5% for fiscal 2017. Demonetisation, it said, would badly hit the informal economy which forms 40% of India’s GDP.

Certain sectors, especially the cash-intensive ones, would suffer more than others. For instance, real estate, manufacturing, and small and medium-sized businesses are already seeing a major drop in activity. Realty demand has slumped and diamond cutters and polishers have stopped operations. Here’s how demonetisation has affected the various sectors:

Sector Impact
FMCG Sales dropped, rural demand hit.
Auto Sales down in November, consumers postpone purchases, impact seen more in rural areas.
Banking Deposits rise, lenders could cut interest rates.
Real estate Short-term demand falls, transparency could increase in the long run.
Diamond cutting & polishing No wages for workers, industries in Surat hit with temporary halt in operations.
Manufacturing The November purchasing managers index for manufacturing dropped as production, buying activity, and new orders were hit.

Tax raids

Predictably, the overall turmoil hasn’t left the banking sector untouched. While instances of hoarding of the new notes have been reported from many parts of the country over the past month, in many places, banks themselves have been part of the plot.

In a series of raids, officials of the income tax department have unearthed huge amounts in the new currency from bank officials, besides politicians and builders.

India’s third-largest private lender, Axis Bank, came under fire after its multiple branches were raided and employees found to be laundering money in new currency notes. One of its Delhi branches was found to have created some 44 fake accounts with Rs100 crore deposited in them. Earlier, another 20 fake accounts were found at another Delhi branch with Rs60 crore in deposits.

Axis Bank managing director and CEO Shikha Sharma, though, has called them “isolated incidents.” While it has acted against the accused employees, the lender’s reputation and stock have taken a hit. Its share price has dropped 3% since demonetisation.

Bewildered economists

Many well-known economists, such as Harvard professor Kenneth Rogoff and former Indian prime minister Manmohan Singh have, meanwhile, criticised demonetisation.

Although, Rogoff, a leading voice on the subject, said it was difficult it was very difficult to gauge any impact. “The short run costs are unfolding, but the long-run effects on India may well prove more than worth them, but it is very hard to know for sure at this stage,” he wrote in November. While he agreed that high-value currency notes were a key reason for illegal activities in any economy, he said demonetisation ought to be executed slowly. “My approach eliminates large notes entirely. Instead of eliminating the large notes, India is exchanging them for new ones, and also introducing a larger, 2000-rupee note, which is also being given in exchange for the old notes,” he said.

Singh, who liberalised the Indian economy during an earlier role as the country’s finance minister, called Modi’s policy “a mammoth tragedy.” “This brazen policy measure has neither tackled the stock of black money holistically nor has it stemmed the flow of it,” Singh said in a Dec. 09 editorial in The Hindu newspaper.

Modi offered his defence. “This decision (demonetisation) is so huge that even our best economists remain confused in their calculations. India’s 1.25 billion citizens, however, have welcomed it wholeheartedly and supported it even in the face of great personal difficulties, intuitively understanding its impact and importance,” he said on Dec. 29.

The pain might be worth it

Amid all the criticism, some experts have also thrown their weight behind the move.

Economists like Columbia University’s Jagdish Bhagwati have called it “daring.” In a Dec. 13 editorial for The Times of India newspaper, Bhagwati, along with academics Pravin Krishna of the John Hopkins University and Columbia’s Suresh Sunderesan, wrote that “despite significant transition costs, (demonetisation) has the potential to generate large future benefits.” They said:

While the pernicious effects of a large black economy and tax avoidance have been well recognised, no tangible policy action has been taken until now. Modi’s radical move to invalidate the high denomination notes, in which the black economy primarily transacts, is a daring step.

They also explained that Modi’s policy has got support from all sections of the society and that the policymakers must handle the process efficiently to “ensure sustained support from the common man.”

RBI governor Urjit Patel has indicated that the pain is short-term and demonetisation only means a better future for the economy in the long term. “The withdrawal of specified bank notes will impart far-reaching changes going forward. It is expected to significantly transform the domestic economy,” Patel said in the RBI’s financial stability report released on Dec. 29.

India’s eventual transformation into a cashless economy is expected to bring transparency to the financial system besides saving up on printing paper currency. Consulting firm McKinsey estimates a 11.8% boost to the GDP by 2025 if the country moves to digital finance.

India has had a dismal record when it comes to tax payments. In 2013, only 1% of the country’s population paid income tax. So, most Indians just hoard wealth as cash, gold or real estate.

“There are only 24 lakh people in India who accept that their annual income is more than 10 lakh rupees. Can we digest this? Look at the big bungalows and big cars around you,” Modi said on Dec. 31. Perhaps the Indian prime minister has more up his sleeve to overhaul financial transactions and taxations in India.

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