Critical Analysis on Demonetisation

On November 8, in an urgent move, Prime Minister Narendra Modi announced the ‘Demonetisation’ of Rs. 500 and Rs. 1000 currency notes. The swiftness of execution was such that these currency bills were effectively rendered useless within a couple of hours of the announcement. The reasoning behind such a move has been summed up in the official statement. A striking observation to be made out here is the lack of data numbers provided for by the Government and the connection made to national security. Let’s think about this policy action to analyse it to a certain extent.

The entire argument for or against demonetisation, essentially, depends upon the magnitudes of counterfeits and unaccounted cash. In the absence of data numbers as evidence, we lose context which then is substituted by our imagination and/or hearsay.  In case of black economy and counterfeit circulation, guess estimates vary widely. Popular lower bound for the shadow economy is said to be  around 20% of GDP. Other estimates suggest it is 75% of GDP.   However, with Black Money Economy it is important to understand the amount stacked up as cash as a proportion of total against which demonetisation is effective. There is not a great deal of information available about the same but estimates suggest that it is around 3% of the total.

I don’t want to execute a cost benefit analysis of the move in terms of monetary values. Demonetisation is a good instrument to deal with cash hoarding especially because the mad scramble to derive value out of the cash stocks that it initiates is effective in bringing out dormant cash into circulation giving impetus to the economy. The existing cash stocks are disposed off, converted into other forms or exchanged by the new currency. However, the execution in this case feels premature and inadequate. One line of reasoning that demonetisation has is to remove higher currency bills as they promote corruption, terrorism, tax evasion and illegal immigration. One goes from a trunk to a suitcase as the denomination increase. But this government is not thinking along those lines as it has come out with a Rs2000 note, alongside the old denominations in newer design. The reasoning given for the same is that it facilitates exchange in the present; but in this situation of poor liquidity the same has been causing problem as smaller denominations are not available readily.

If we presume that the next demonetisation is not likely to be executed in the next two decades, then would it be too far-fetched that this move is only a reset button which wipes out hoarded cash and begins a new cycle with newer tools? Although the time lapse before the shadow economy builds the same cash stock would be significant, one can’t discount the ingenuity of the black money operators in finding alternative mechanisms.One major cause for concern is that this policy action does not attack the unaccounted assets such as estates/gold/foreign currency/bank accounts or any other national or international instruments such as Panama Papers, which together constitute a higher proportion. Estimates suggest that this proportion is around 90%. Black economy is usually characterised by flow and not static cash is an argument that has been gaining prominence. Under such a scenario, attempts by anyone to put this policy action on a pedestal that suggests it is a panacea for black money economy may be misplaced. This demonetisation is not likely to affect much of the illegal activities that generally gets a collective label of ‘Black Money’. Although the government has not made explicit its targets from this exercise, one is likely misled in believing that the policy affects a lot more than just 3-5% (perhaps 10% if taking a conservative estimate) of the ‘Black Money’ problem.

The other reasoning behind this Demonetisation is the case of curbing fake currency in circulation. The threat to national security is increased if terrorist organisations are able to regularly infuse fake Indian currency notes (FICN). However, the problem is about the incidence of illegal minting and at the source of influx of FICN. Once infused and in circulation, the benefit is already been derived by terrorists. Estimates from RBI suggest that 250 in 10 million notes are fake. Hence, the RBI has from time to time tried to bring in new security features into the currency design to foil counterfeit attempts. The hastiness of demonetisation, however, seems unnecessary if we only consider FINC; currency notes printed before 2005 were gradually phased out as a measure some time back. The gradual manner of the process allowed for smoother transition.

The combination of ‘Black Money’ and use of FINC by terrorists is the marketing aspect of this policy. However, in isolation they do not seem to be significant enough to merit an abrupt implementation of demonetisation policy. Together the aspects paint a seemingly successful picture of killing two targets with one shot but that joint significance gets grossly overstated.

In light of the above, the policy action seems to have been prematurely implemented in an abrupt manner. Given the present rate and friction of transition, it feels that possible pitfalls in logistics were not evaluated entirely. It is almost as if the action is non-cognizant of people that have their entire business model based around cash transactions. It is odd that in the week leading up to the day of announcement, ATM’s were still dispensing denomination of 500 and 1000 instead of 100. In the past year, it was a common feature that ATM’s did not have the Rs100 currency bill. Hence, one had to first get larger denominations exchanged at the nearest store/petrol pump and then make smaller transactions. 86% of the total value of money supply was in 500 & 1000 notes. Is it pragmatic to continue the supply uninterrupted and then call back the bills just a couple of days later? The logic for such a move is supposed to be the maintenance of secrecy of the action to ensure people are caught unawares. It is commendable of the Government that such a policy was brought in without a leak, but that same swiftness of execution has caused the common people hardships. I am not sure if the secrecy of the move is critical to its success. I believe a gradual process, in phases with Rs1000 being demonetised first followed by Rs 500, would have significantly reduced the hardships being faced without compromising much in terms of present efficiency of tackling the problem.

The primal targets are Black Money Hoarders of currency. In 1978, the demonetisation didn’t affect the general population because they didn’t possess the larger denominations. In this case, the denominations were part of daily transactions for most people. Hence, there should have been an initiative to concentrate the now defunct currency bills in the hands of the opulent. For instance, probably an influx of Rs100 currency bills would have created a wedge between cash hoarders and the general population. There was an existing shortfall in supply of the same by 45 crore pieces in 2015-16.  The existing Black Money storage would not have been converted to smaller denominations while the general population would have liked the increase in supply which facilitates their transactions. An increased supply of smaller denomination could have ensured that higher proportion of transactions that are cash based would have carried on unaffected. Given the liquidity constraints the daily cash based transactions for groceries, fruits and vegetables and the likes have been severely compromised, temporarily at the least. If the money supply remains low, these small scale sellers, especially those in perishable goods business, would have been dealt a fatal blow.

If you haven’t yet felt the adverse effects of demonetisation, probably you have access to Debit\Credit Cards or E-Wallet services; but then you are part of a small proportion of the larger population. Consider the case of the vegetable seller at the crossing, or the wholesaler in Sabzi Mandi, or others businessmen who don’t have access to technology which can allow you to swipe a card or scan QR code; their businesses are suffering as the demand has decreased.

Abhi dhanda manda hai.

From effects on GDP and inflation to possible slowdown of real estate sector, there is enough to discuss in the economics of the present demonetisation that this article would fail to do justice. There are genuine positives (for instance addition of dormant cash) and negatives ( e.g. breakdown of informal sector transactions.)

Let’s think about the marketing strategy of this policy. The popular mood feels to be in sacrificial mode; as if Black Money is a tumour that requires chemotherapy in the form of demonetisation and the short term pain is necessary for a better India.  The poor planning in terms of capacity building suggests that the pain is intended. The Government has presented this action as necessary for National Security and in the interest of this nation but I am not sure if it is in favor of the larger population and that hardships are temporary sacrifice for the greater good. We need to question the policy to ensure its aptness and utility.

Personally, I am not a fan of a this tactic which the Government seems to be employing: Don’t provide the details, inspire some patriotism, throw in the idea of an ever growing terrorist threat alongside an empowered Pakistan, and the rest is supplied by the mind with imagery from Bollywood. It gives an image of ‘something being done’ while the larger problem might escape popular imagination. The expectations are that there might be future actions to control the ‘Black Money Economy’ phenomena, but at present, it would be just guess work to think what those might be, if any. Inflating this policy to suggest that it is a super effective measure against the black money might just be a cunning plan; but then Baldrick had a plan.

I am not against Demonetisation per se, but there is enough discontent against the execution in the present context. The rampant misinformation that this policy breeds is devastating to the financially illiterate and insecure. At the same time there have been incidents of housewives committing suicides and lives being lost for lack of healthcare in absence of valid currency bills. When people’s livelihood are at stake, it is an emergency. There are long term efficiency gains to be had if the economy moves to a cashless form but there has to be proper implementation of technological equipments for transaction on the supply side and increased financial training on the demand side. In the meantime, even though the way forward is full cooperation, the government should be aware that if this transition is successful, it would be because the population is resilient and willing to go the distance for the country. One can even say that a smooth transition to new currency would be inspite of the Government’s planning rather than because of its effort, and not be entirely wrong. The queues have been long and the wait seemingly ever-lasting. Therefore, please refrain from advising ‘Don’t Panic’. Yes there might be positives, but is it worth a life in the short run? One can’t answer that…or can you?

P.S: Don’t let social media and popular view guide your opinion entirely, else you would be betting for Hillary and Trump would happen! There are enough perspectives from both side of the alley; form your conclusions cautiously.



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