Demonetisation: A Thunderbolt in Search of a Target

Enough has been written about the sudden demonetisation that was sprung on the country by Prime Minister Modi on 8 November 2016. The pros and cons of it have been discussed in detail over the last month and I have nothing more to add beyond what has already been stated by first-rate minds in India and abroad. Economists of impeccable reputation have commented on it and have warned that the move is likely to hurt the economy in the short run. See, for example, commentaries by Amartya Sen,[1] Kaushik Basu,[2] Paul Krugman,[3] Larry Summers,[4] Kenneth Rogoff,[5]  and Gita Gopinath[6] among others. In a major shift in his opinion, Deepak Parekh now believes that demonetisation will derail the Indian economy.[7] Even Arvinda Pangariya, Vice-Chairman Niti Ayog (formerly the Planning Commission) has acknowledged that there will be short-term costs and that the process of demonetisation has been poorly managed.[8]

To be fair, there are others – Bibek Debroy,[9] Surjit Bhalla[10] and Bill Gates (though he changed his mind pretty quickly[11]) - who have supported the move by the government. In fact, Bibek Debroy has taken to task the economists who have had the temerity to criticize demonetisation: “They (i.e. economists living abroad) base their understanding essentially on reading English newspapers. Otherwise, how would they know? English language newspapers understood many things wrongly”.[12] So, the economists are wrong because they do not live in India. Alas, this is the usual ploy of attacking the critics when the criticism cannot be effectively answered.

In all the sound and fury surrounding demonetisation, the silence of one economist has been deafening: the government’s own Chief Economic Advisor (CEA) Arvind Subramanian. When the government has been struggling to answer the criticism levelled against demonetisation, would it not be obvious to field its CEA to respond to the critics? But he has been missing in action.[13] Perhaps the government does not trust him enough or perhaps, invoking what Subramanian Swamy had said about Raghuram Rajan,[14] the CEA does not know enough about India since he is not Indian enough.

Searching for a Rationale of Demonetisation

Curbing Black Money

During the course of the last month, the objectives of the demonetisation drive have been changing continuously. The initial focus was on curbing black money. However, it soon became apparent that this was unlikely to reveal a large amount of black money since only about 6% of such money is kept in cash. Moreover, the generation or flow of black money has remained unchecked and all that demonetisation could, optimistically, hope to achieve was extinguish only a small fraction of the huge accumulated stock of black wealth. Consequently, it is not at all surprising that suspicious amount of money in the form of new currency notes have been recovered during tax raids.[15]

The above criticism of demonetisation is reinforced by a recent statement of the Revenue Secretary in the Finance Ministry who has stated that the government expects all scrapped Rs 500 and Rs 1,000 notes to come back to the banking system which then raises questions about the very purpose of the hugely disruptive demonetisation exercise.[16] It may be remembered that the government expected that, of the Rs 15.4 lakh crore of scrapped money, 30 per cent or Rs 4.5 lakh crore was black (i.e. this money would not find its way back to the banks). It is now being accepted that at most one-third of the Rs. 4.5.lakh crore may be black money and, with the deadline for depositing now defunct notes in banks still some weeks away, even less black money is likely to caught.

Cashless Economy

As the hollowness of demonetisation as a means of controlling black incomes has become apparent, a wonderful world of cash-less economy has been dangled in front of the country. The Prime Minister has exhorted rural audiences in his election rallies in the Punjab to think of their mobile phones as banks.[17] Given that much of rural India does not even have access to banks, this seems like a cruel joke. While access to banks has increased with the Jan Dhan accounts opened during the last two years, the percentage of persons in rural areas without bank accounts is still significant.[18] Moreover, many of the Jan Dhan accounts have a zero-balance which suggests that the size of unbanked population may be declining but the numbers of those actually using banks continues to remain low. But a sneaky game is afoot: banks have been depositing one rupee into the zero-balance accounts so as to reduce the number of such accounts![19]

A cash-less society is a chimera which does little to alter the depressing reality where mere access to banks is still a challenge, leave alone usage of mobile banking and plastic money. This is not the criticism of a technophobe but rather a plea to recognize the reality of the society we live in. Before one talks of cashless society, it is important to ensure the spread of banking which, if pursued relentlessly, is likely to meet with much greater success in curbing black money. One cannot leapfrog into cashless society from one which still conducts 68% of its transactions in cash.[20] Forcing people to do so requires coercion and does not sit well with democracy. Cultures and habits of the populace do change but certainly not at the behest of a government diktat.

Reduction in Violence in Kashmir

The desperation of the government to see some silver lining to the disaster of demonetisation became starkly apparent when the Defense Minister, Manohar Parrikar, made the fantastic connection between monetary policy (i.e. demonetisation) and the violence in Kashmir.[21] Parrikar’s absurd claim cannot be taken seriously by anyone who has studied the Kashmir problem.[22] The incidence of stone-throwing had been exhibiting a declining trend even before the announcement of demonetisation: in July 2016 there were 820 incidents; in August, there were 747; in September, there were 535; in October, this had fallen sharply to 157. This pattern has merely continued in November and would have done so quite independently of demonetisation. It was not monetary policy that did the trick but time-tested policing as stated by a police officer: “We have detained the provocateurs of violence and those people who were instigating the youth to pelt stones. All these measures are showing the results”.[23] By attributing the decline in violence to demonetisation, the Defense Minister does great disservice to our police who have brought under control one of the worst episodes of violence in Kashmir.

Putting the Opposition on the Mat

As demonetisation has spun out of control and is not the surgical strike that it was claimed to be, the government and the BJP have gone on an offensive. How else does one explain the impossible claim of Amit Shah, President of the BJP, that black money will vanish from India by the end of 2016?[24] Shah has also been tasked with demolishing former Prime Minister Manmohan Singh stinging criticism of the government in Parliament when he referred to demonetisation as organized loot and legalized plunder.[25] The BJP and its acolytes have reacted in the only way they can: by attacking the critic but leaving the criticism unanswered. It was left to Amit Shah – using of combination of half-truths and downright lies – to try and do a demolition job on Manmohan Singh.[26] While there is no attempt to answer the criticism, Shah seeks to demolish Manmohan Singh’s stature as an economist by claiming that a non-economist Prime Minister before Singh (i.e. Atal Bihari Vajpayee) and tea-seller Prime Minister after Singh (i.e. Narendra Modi) had delivered better growth to the Indian economy. Such nonsense is music to the ears of the devotees (bhakts as they are derisively called) of the BJP for whom facts and truth are an inconvenience to be ignored or changed at will. However, those who have the slightest respect for facts and truth will recognize the fake news that Shah is purveying.

Shah said that, when Vajpayee demitted office, India’s growth rate was 8% while at the end of Singh’s term in office it was 4%; ergo, Vajpayee managed the economy better. I see absolutely no reason why one should focus only on one specific year in the term of a government? Perhaps because it helps to advance a fake narrative? The chart below shows a comparison between full terms of Vajpayee’s government (NDA-1) and Singh’s governments (UPA-1 and UPA-2). Incidentally, the data I use is verifiable and sourced from one of the most respected institutions in the country, namely, the Reserve Bank of India.[27]

The average for the entire term of NDA-1 is 5.88% per annum; for UPA-1, it is 8.43% per annum; and for UPA-2 (despite the slowdown in the last two years) it is 6.88% per annum. It should also be mentioned that, despite the worst world-wide recession in about a century during 2008-09 to 2010-11, the UPA, not only protected the Indian economy from its ill effects but, in fact, delivered growth rates of 6.72%, 8.59% and 8.91% during those years. It is only in 2011-12 that the Indian economy began to run out steam to internal reasons (such as, policy paralysis) and pressures from the weak performance of the global economy. But, of course, for the committed supporters, such facts don’t matter. Isn’t it amazing how blind support is so similar in the two largest democracies – India and the USA – in the world? In both countries, there has been the disturbing tendency for uncritical supporters accept fake news as truth and reject truth as fake.

Shah further stated that the NDA-2 government, over its two completed years in office, had delivered growth of around 7.5% per annum which is better than the 4% growth rate that it inherited. Anyone with a rudimentary knowledge of arithmetic knows that the 4.74% rate that was actually achieved in 2013-14 (see Figure 1) is rounded up to 5% and not rounded down to 4%! But that is a minor travesty. The bigger one is the fact that the way of measuring GDP has undergone a change from January 2015[28] and this has been ignored by Amit Shah. The changed methodology has been used to report a new series of GDP from 2011-12 onwards. As a result, for the years, 2011-12, 2012-13 and 2013-14 (the last three years of the UPA-2) two different sets of GDP data are available. Hence, while making comparisons, it is important to select GDP data that are comparable. Specifically, when comparing the GDP data for the last three years of UPA-2 with the first two years of NDA-2, one must use the new series of GDP introduced in 2015.

In view of the above caveat regarding comparison, the rate of growth of around 7.5%  under NDA-2 as per the new methodology cannot be compared with rate of 4.74% rate in 2013-14 (last year of UPA-2) as per the old methodology. A cavalier comparison, as done by Amit Shah, would be like comparing the weight of one person in pounds and that of another in kilograms and using these weights to decide who is heavier. The correct comparison – using the same methodology to measure GDP during the two regimes – is given in the chart below.

Now, the comparison between the rates of growth in the last year of UPA-2 with that of the two years of NDA-2 is meaningful. Note that the growth rates during the last two years of the UPA-2 are higher as per the new methodology. The rates were 4.47% (2012-13) and 4.74% (2013-14) as per the old methodology (see Figure 1) while, as per the new methodology, the rates are 5.62% and 6.64% (Figure 2). Given this, Amit Shah’s correct comparison should have been between the rate of growth of 6.64% in 2013-14 with 7.24% in 2014-15. It is now obvious that the difference between the two growth rates is not as bad for the UPA-2 as has been made out by Shah and other ill-informed critics.

It is certainly true that, even as per the new methodology, the performance of UPA-2 did drop in the last two years of its rule but that certainly does not qualify, by any stretch of imagination, as a destruction of the economy, as has been claimed. For a more detailed discussion, readers are invited to have a look at an earlier post of mine entitled “Did the UPA Destroy the Economy? A Counterfactual Exercise”.[29]

Long Term Benefits of Demonetisation

As the demonetisation story has unraveled and there seems to be no sign of any immediate benefit, the spin doctors have pulled out the allure of long term benefits out of the bag of tricks. Finance Minister Arun Jaitley has claimed that “When you are in a cusp of history and you look at the long-term impact of these steps which are going to be taken, I think India is going to become a society in the long term with a certainly better GDP, cleaner ethics, a cleaner economy”.[30] So, what happened to Modi’s tearful cry from the heart which asked for forbearance for 50 days, after which all pain would vanish? As the short-term benefits (if any) have been overwhelmed by the huge short-term costs, the government has thought it best to dangle a vision of paradise in the distant future – since this can never be verified, anything good that happens to the Indian economy in the future can be attributed to demonetisation.

Long term growth requires consistent, stable and predictable policy-making which then allows private businesses/producers to plan for the future. A severe disruption to the system, like demonetisation, creates doubts in the minds of producers about the policy regime likely to prevail in the future. The natural reaction of risk-averse producers is to postpone crucial investment decisions awaiting clarity regarding the direction policy is likely to take. Over the last two years, private investment has been sluggish at best and demonetisation is likely to act as one more stumbling block for investment decisions. Anyone familiar with the Solow growth model is aware of the importance of private investment in determining growth in an economy. Hence, any disruption that damages the confidence of private players to invest cannot but lead to a drop in investments and, hence, in growth rates in the future.

It is true that numerous cross-country studies have revealed that economies that are low in corruption have been found to perform better.[31] However, demonetisation has been seen to be anything but an anti-corruption measure. The Prime Minister’s threat of letting loose tax officials to unearth black wealth will achieve nothing apart from causing immense turmoil to the lives of law-abiding citizens while those with illegal wealth would have squirreled it away from the reach of tax officials. Controlling corruption requires changing the incentive structure for generating illegal incomes. This can happen only when bureaucratic controls are loosened, tax administration is simplified and ease of doing business is improved. None of the measures on display so far will have the slightest impact on corruption and, hence, no beneficial impact on India’s growth.

Summing Up

Having examined the various possible rationales that have been trotted out to justify the demonetisation unleashed by the Prime Minister and found little evidence to back these up, the question remains as to why this step was taken at all? How could a politician, as astute as Narendra Modi, have taken such a momentous step without weighing up the costs of this decision and the damage this might do his and his party’s popularity? I am not in slightest suggesting that the NDA’s hold on political power is about to be threatened. With the opposition so completely fragmented and the Congress in thrall of an inept leader-in-waiting, there is little danger of any meaningful challenge to the NDA. But, even for a leader confident about his position, there is a constant need to keep playing the messianic role that he has arrogated for himself. As the months have rolled on and half the term of the government has been completed, there have been no eyeball-grabbing achievements that the BJP can boast of to keep the BJP supporters enthusiastic and galvanized for the 2019 elections. Hence, something dramatic was required. The mundane task of governance was clearly not enough to keep intact the popularity of the leader. For example, the perfectly admirable task of improving the ease of doing business in India was taking too long to show dramatic results and hardly made for histrionics at public meetings. India’s position in the World Bank’s Ease of Doing Business has certainly improved since 2014 but it continues to languish at a rank of 130 among 190 nations.[32] Changing the sclerotic bureaucratic structure is not easy and is unlikely to show results in a hurry. Possibly, realizing that the hard grind of governing a country was not “sexy” enough to enthuse the fanatical supporters of Modi, a dramatic gesture was needed and it arrived as a thunderbolt on 8 November 2016. And, certainly, in the days that immediately followed the announcement, whoops of joy and enthusiasm filled the air as the credentials of a muscular, risk-taking leader were reestablished.

As things stand, the costs of demonetisation seem to far outweigh the benefits, if any. Will the schadenfreude at the discomfiture of those with illegal money, experienced especially by the poor, continue despite the immense hardship and the livelihoods that have been put at peril? That is something that the future will reveal but we can be sure that the innovative and imaginative spin doctors of the BJP will have their hands full for some time to come.

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[1] http://www.thehindu.com/news/national/Amartya-Sen-terms-demonetisation-a-despotic-action/article16730675.ece

[2] http://www.nytimes.com/2016/11/27/opinion/in-india-black-money-makes-for-bad-policy.html

[3] http://www.livemint.com/Politics/6WQRkoCktgAJdagFSkcIVN/Demonetisation-may-not-deliver-long-term-benefits-to-India.html

[4] http://thewire.in/81659/larry-summers-on-demonetisation-india/

[5] http://blog.press.princeton.edu/2016/11/17/kenneth-rogoff-indias-currency-exchange-and-the-curse-of-cash/

[6] https://www.project-syndicate.org/commentary/india-tax-evasion-demonetisation-by-gita-gopinath-2016-11

[7] http://www.news18.com/news/business/in-major-u-turn-deepak-parekh-says-demonetisation-has-derailed-economy-1320467.html

[8] http://www.financialexpress.com/economy/demonetisation-liquidity-issues-to-stay-for-three-months-says-arvind-panagariya/456488/

[9] http://www.business-standard.com/article/economy-policy/bibek-debroy-counters-ex-pm-manmohan-singh-on-demonetisation-116112600005_1.html

[10] http://indianexpress.com/article/opinion/columns/demonetisation-of-rs-500-rs-1000-notes-new-rs-2000-note-big-bang-or-big-thud-4383065/

[11] http://www.business-standard.com/article/economy-policy/bill-gates-makes-a-u-turn-on-demonetisation-116111800040_1.html

[12] http://indianexpress.com/article/india/india-news-india/economists-criticism-of-demonetisation-not-fact-based-niti-aayog-member-bibek-debroy-4397845/

[13] http://thewire.in/83452/chief-economic-adviser-arvind-subramanian-missing-action/

[14] http://www.ndtv.com/india-news/remove-raghuram-rajan-subramanian-swamy-writes-to-pm-narendra-modi-1407047

[15] http://www.ndtv.com/bangalore-news/bengaluru-raids-reveal-5-crores-mostly-in-new-notes-also-a-lamborghini-1632774

[16] http://economictimes.indiatimes.com/news/politics-and-nation/all-pain-little-gain-demonetisation-math-does-not-add-up/articleshow/55854776.cms?prtpage=1

[17] http://www.newindianexpress.com/nation/2016/nov/25/pm-modi-pitches-for-mobile-banking-1542567.html

[18] In 2015, it was as high as 50% which would have come down in 2016. https://rbi.org.in/Scripts/AnnualPublications.aspx?head=Basic%20Statistical%20Returns

[19] http://indianexpress.com/article/business/banking-and-finance/how-banks-cut-their-zero-balance-jan-dhan-accounts-one-rupee-trick-3028190/

[20] http://www.business-standard.com/article/economy-policy/infographic-68-of-transactions-in-india-are-cash-based-116111400495_1.html

[21] http://timesofindia.indiatimes.com/india/Demonetisation-has-led-to-decline-in-separatist-instigated-violence-in-the-Valley-MHA-sources/articleshow/55419257.cms

[22] http://thewire.in/81378/kashmir-stone-pelting-demonetisation/

[23] http://thewire.in/81378/kashmir-stone-pelting-demonetisation/

[24] http://economictimes.indiatimes.com/news/politics-and-nation/by-year-end-india-wont-have-black-money-amit-shah/articleshow/55833192.cms

[25] http://www.ndtv.com/india-news/monumental-management-failure-dr-manmohan-singh-on-notes-ban-1629571

[26] http://aajtak.intoday.in/video/agenda-aaj-tak-amit-shah-in-talk-with-rahul-kanwal-1-900256.html

[27] https://www.rbi.org.in/Scripts/AnnualPublications.aspx?head=Handbook%20of%20Statistics%20on%20Indian%20Economy

[28] http://mospiold.nic.in/Mospi_New/upload/Changes%20in%20Methodology%20NS%202011-12%20June%202015.pdf

[29] http://ajitkarnik.blogspot.ae/2014/06/did-upa-destroy-economy-counterfactual.html

[30] http://www.thehindu.com/business/Economy/%E2%80%98Benefits-of-demonetisation-to-accrue-in-long-term%E2%80%99/article16773645.ece

[31] ftp://ftp.iza.org/dps/dp5334.pdf

[32] http://www.doingbusiness.org/rankings