‘Modi’fying the Indian Economy – 2 Months of Demonetization

Digital media and news broadcasters virtually erupted on the evening of November 8, 2016, as Narendra Modi, Prime Minister of India announced demonetization of INR 500 and INR 1,000 notes. He declared that 86% of the value of money held in notes of INR 500 and INR 1,000 would become illegal with the stroke of midnight, and granted a 50 day period for the population to redeem their negated cash for newly designed INR 500 and INR 2,000 notes.

Hoping to see a ‘Modi’fied country, he gave two primary reasons for this decision; to “break the grip of illicit cash and black money on the economy” and to “check enemies from across the border using fake currency notes”. The public called it a masterstroke, while the political opposition stood against the act calling it an ‘imprudent’ move that penalizes common man and is akin to burning down the forest to catch a few black sheep.

As Modi had already shot the arrow hoping to establish a new level of equilibrium, I wanted to share my thoughts on the happenings at the opportune time of the 2nd month commemoration of this historic and bold decision. Yes, today is exactly the 60th day, and here’s something you should know about India’s long-standing relationship with demonetization, and what it has brought us all as a nation.

Has India implemented demonetization before?

Before discussing the current state of affairs let us take a peek in the history. This is not the first time India has implemented demonetization. The Government announced its first demonetization way back in 1946. Reserve Bank of India (RBI) had introduced INR 10,000 notes in 1938, and the rich hoarded money, at the expense of hyperinflation. Being on the verge of independence, the Government banned denominations of INR 500, INR 1,000 and INR 10,000 in 1946 to curb black money. But the bold move of demonetization in the past turned out to be a currency conversion drive, as the high currency notes were accessible only to the rich mass.

Demonetization shook the country again in January 1978, with the banning of INR 1,000, INR 5,000 and INR 10,000 notes. People who possessed these notes were given merely a week’s time to exchange any high denomination bank notes. However, it went away as an ineffective move without impacting the economy much, as higher value notes were not a part of the common man’s wallet, then. The circulation of these high-value notes was barely 2% of the total currency, as compared to today’s 86% which definitely is a big concern for the Government.

Hence, there is a big difference between demonetization, now and then. After all, did the hope of curbing black money end here? Though we’ll discuss the real parameters of demonetization in the later part of this blog, let’s quickly see if any other countries across the globe implemented demonetization in the past.

Has any country implemented demonetization in their economy?

While demonetization has worked for some countries, it has been a big reason for the complete breakdown of the economy of other countries.  It depends on the execution plans that decide whether demonetization will jolt the economy or drown the country drastically.

Several countries have embraced this policy in the past, as a measure to tackle the problems of black money and counterfeiting. Some met the purpose, whereas some failed miserably. The major demonetization phenomenon of the modern currency was the introduction of Euro when all EU nations demonetized their currency and started using Euro.

Some success stories of implementing demonetization are as follows.

  • In 1969, President of USA, Richard Nixon announced all notes above USD 100 null and void. Even today USD 100 notes are the maximum available for circulation.
  • In 1996, Australia became the first country to circulate a full series of polymer bank notes, after replacing all paper-based notes, which was systemically declared non-tender for legal purposes.

However, we have some examples where demonetization proved to be a disaster. In 1982, Ghana ditched their 50 cedis note to tackle tax evasion and pour out excess liquidity. This made the people of the country invest heavily in physical assets, which visibly turned the economy weak. In 1984, Nigeria, the debt-ridden and inflation-hit country wasn’t able to steer the change properly, and the economy collapsed.  In 1987, Myanmar’s military quashed around 80% value of money to restrain black money. The decision led to an economic disruption which in turn led to mass protests that affected lives of many people.

In 1991, Soviet Union’s Mikhail Gorbachev addressed the nation to withdraw large-Ruble notes from circulation in order to curb the black money. The move choked the economy, which resulted in a coup attempt that brought down his authority and led to the breakup of Soviet Union. A demonetized North Korea left people homeless and starving in the year 2010. Kim-Jong ll introduced a reform that knocked off two zeros from the face value of the old currency in order to curb black money.

The cost-benefit analysis of demonetization

Cost of demonetization

According to the Centre for Monitoring the Indian Economy (CMIE), the transaction cost of demonetization until December 30, 2016, was estimated at around INR 1.3 trillion. This estimation equalizes 0.9% of the GDP; in literary terms, it is ‘thousand rupees per individual’ of this country. CMIE marked this move as a conservative estimate. Also, the CMIE has informed that the cost will rise if the chaos continues until the end of the financial year.

The country’s GDP in FY 2016-17 and FY 2017-18 is also getting affected as a result of this disruption. RBI estimates a GDP drop of 0.5% in FY 2016-17 and our former Prime minister, Dr. Manmohan Singh estimates a 2% drop in GDP in the next financial year, which alone would mean a loss of around INR 3 trillion. Thus, the cost to the country over a period of 15 months from the very act of demonetization can be around INR 4.3 trillion.

In addition to the financial cost, ’the doom for the dishonest’ affected the common mass and lives crippled. At least 33 people have reportedly succumbed to death due to incidents related to demonetization. The inconvenience is not getting over any time soon, as there are only four note printing presses in India that are all into producing new notes. Based on the current capacity of the printing presses, it will take 6 to 12 months to print and circulate the new notes – even if the usual two shifts of printing per day is taken up to three shifts.

Benefits of demonetization

It is estimated that there is around INR 6 trillion of illicit cash out of a total of INR 15.44 trillion in circulation as on November 8, 2016. The Government of India has not specifically laid down its measure of success. But its counsel has informed the Supreme Court that the Government expects that around INR 5 trillion illicit cash will not come back into the banking system through loopholes. So, that can be considered the Government’s benchmark of success. The maximum “benefit” is INR 6 trillion – i.e. all the illicit notes are not received by the banks and the black money in cash becomes extinct or near-extinct. The black money that does not come back to the system will be given to the Government as a special dividend from the Reserve Bank of India.

The cost-benefit analysis

On January 4, 2017, Bloomberg reported that banks had received INR 14.97 trillion as of 30 December, of a total of INR 15.44 trillion in circulation as on November 8, 2016. This amounts to 97% of the cash under circulation. However, the RBI said that these estimates may be incorrect until the reconciliation process is over.

As per the last announcement on December 7, 2016, by R. Gandhi, Deputy Governor of the Reserve Bank; INR 11.85 trillion had already been deposited in banks, referring to INR 3.59 trillion still left to be deposited.

So, it appears that the cost outweighs the benefits in the short term. Of course, this move may set the country on the path to digital financial transactions and increase the tax base over the long run.

Change of goal post from ‘curbing black money’ to ‘going digital and cashless’

By setting the nation narrative, the Government has been criticized for the possible failure of demonetization by its political opposition and some eminent economists like Paul Krugman, Manmohan Singh, Amartya Sen, Kaushik Basu, Larry Summers and Raghuram Rajan. As pointed by the naysayers of demonetization, opponents have argued that the amount of black money in cash could be really small. Though there are no official estimates of black money held in cash, experts say only 3-6% of the total black money is in cash. The rest is in gold, real estate, stocks, foreign exchange and off-shore accounts.

Neither the argument around fake currency seems to hold. Only 0.002% of the total currency in circulation is counterfeit. This means that out of every 1 million currency notes in the system, only 250 are fake notes. This is a statistically insignificant number. These are some of the reasons why the Government has changed its rhetoric from ‘a movement to curb black money’ to ‘a digital and cashless revolution’.

Dream of making India a cashless economy

Since the demonetization drive, small-scale vendors (eg. tea stalls, grocery stores) and consumers in rural and smaller cities have started embracing digital payments through mobile wallets and bank point-of-sale machines. Paytm reported a three-time surge in new users – taking on over 14 million new accounts in the month of November alone. Since the announcement of demonetization, India has a seen a 500% increase in its digital transactions. Furthermore, the Government has innovated numerous schemes and initiatives to promote digitalization. Efforts are being made to help users with feature phones, and non-internet users to go cashless.

Nandan Nilekani, the Chairman of the Unique Identification Authority of India, believes that India was bound to go digital largely in the upcoming six to seven years, but Narendra Modi’s demonetization move has hastened the process and the country will have a digitized economy in a matter of months. The digitization efforts will render enough data, which in turn can be leveraged for developing a host of efficient digital applications, including better credit facilities for small and medium businesses, and customized insurance and savings products.

However, the effort to turn the nation cashless is not simple or short. It is estimated that only 5% Indians make digital payments, while the rest make use of cash. Only 34% of the population has access to the internet. Four of every five Indian villages lack the establishment of banks and financial institutions. With such stats on the desk, imagining the condition of 80% villages in the country can leave anybody astounded.

The informal sector is highly cash-intensive and accounts for 45% of the nation’s GDP. It also makes up 80% of employment strength in India. As estimated, there are 21,000 unorganized mandis (market) in the country and 38.3 million unorganized small and medium-sized businesses. 92% of sales in the FMCG category take place across micro-retail stores, otherwise called as ‘kiranas’. Only 1% of these small-scale vendors use digital modes of payment. In India, 95% of debit card transactions take place for withdrawal of cash from ATMs. Only 5-10% of debit card transactions are used to buy goods or services at a retail outlet.

On the other hand, installing card-swipe machines in shops takes more than two weeks. It needs documentation, scrutiny and even a visit to the firm before a machine is installed. And since these machines are imported, they take time for delivery, even with a lower excise duty. Due to increased volume of digital transactions, the servers in the system have started crashing and need to be upgraded. Other phone-based payment systems are effective but involve a level of literacy higher than swipe card machines. And finally, vendors are not willing to pay the charges ranging from 0.6% to 2.5% on the usage of the card, neither the buyer is eager to.

As it has continued to pan out, issuing grand prophecies and predictions at this point of time is impossible. Big plans take long to show results.

Where are we going with demonetization? My final thoughts!

Removing high-denomination currency notes fits well within the Government’s successful efforts at financial inclusion through Jan-Dhan Yojana, and using technology as an enabler through Digital India. Demonetization is a brilliant political move by our PM Modi. It’s something that every single voter will get to know about – no exceptions. The idea is laudable, but the implementation is challenging, and the consequences are debatable. We might perceive the revolutionary step as a combination of poor economics, shoddy management, solid PR, and very clever politics.

This, however, is not to raise questions about the abilities of the prime minister to deliver but to merely outline the challenges which are an integral part of such a transformative process along with the hope of a more formal and digital economy which will definitely serve the national interest. This move will be marked successful if the Government follows it up with the Benami Property law and by pushing through the Goods and Services Tax. If the reforms turn successful, they would transform the face of the Indian economy. I am not talking about mere growth in GDP, but of a fundamental structural change.

Disclaimer:

The views and opinions expressed in this article are solely those of the author(s) and do not necessarily reflect the official policy or happening of SG Analytics.

Steve Salvius
Steve Salvius
About the Author

Steve heads the Investment Banking & Valuation team at SG Analytics. He has over 8 years experience in offshore investment banking and private equity support. Before joining SG Analytics, he was associated with UBS. He has rich experience in managing multiple client engagements including mid-market and boutique investment banks across the US, Europe, and the Middle East.

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