The Impact Of Demonetisation: Cutting Through The Noise With Numbers

18/11/2016 1:43 PM IST | Updated 21/11/2016 10:45 AM IST
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Senior citizens wait to deposit and exchange 500 and 1000 rupee notes in Amritsar, India. (Photo by Sameer Sehgal/Hindustan Times via Getty Images)

"We have decided that the five hundred rupee and thousand rupee currency notes presently in use will no longer be legal tender from midnight tonight." India was left reeling on the evening of 8 November as Prime Minister Narendra Modi announced his thus-far closely guarded drive for demonetisation.

The move is aimed at curbing the use of black money, to deal a blow to counterfeit currency and to scupper terror financing that often takes place with fake currency. Here, black money refers to income that has not obtained through legal means, and/or income that has not been declared for tax purposes.

Given that the cost to clean up ₹400 crore of fake money may run to more than ₹12,000 crore, it's hard to comprehend the rationale.

The magnitude of what the prime minister was proposing seemed almost unthinkable. India is the world's third largest economy and Asia's second biggest in purchasing power (2015) at $7.98 trillion. In nominal GDP, it is the seventh largest at $2.07 trillion. To support this GDP, India's central bank, the Reserve Bank of India (RBI), has a bank note cash circulation of roughly $255 billion, out of which around 86% was in the highest denominations — ₹500 and ₹1000 notes.

India's cash-intensity in the economy — as measured by the ratio of currency to the nominal GDP — at 12% is significantly higher than Brazil (4.1%), Russia (11.9%) or Mexico (5.7%). This is natural, given that India's per capita income — $1,600 (nominal, 2015) — is much lower than its peers — for example, it is less than one-fifth of that of Brazil ($8,538). A 2012 study showed cash transactions in India to be 86.6% of total transactions, a slight dip from 90.6% in 2007. Estimates presently vary from 68% to even 90%.

So, how wise was this move, which is ostensibly designed to flush black money out of the system? While there are those that are calling it a masterstroke, others are dismissing it as an "unmitigated disaster" driven by political expediency, especially given that the 2017 Uttar Pradesh elections are around the corner.

So, how will this move affect the common citizen of India? With opinions flying left, right and centre, and with the media offering contrasting narratives, this is a good time to examine the bare facts.

Post-implementation chaos

Estimates of black money vary widely. Indian black money kept in Swiss Banks alone is estimated to be in the vicinity of $1.06 trillion although official sources put the figure close to $2 billion.

The existence of a large informal — and parallel — economy in India also complicates any comprehensive and credible study. India's parallel economy (i.e. running on black money) is estimated to be anywhere from 25% to 75% of recorded GDP. The informal economy, on the other hand, is estimated to be around half of the GDP (this figure, too, varies substantially, 30% here), and employs nearly 85% of the Indian population.

Those who understand how markets operate, and the reach and effectiveness of the government in a country like India, could foresee the obvious unfolding crisis.

Best estimates of counterfeit currency indicate a figure of 400 crores, 0.026%, to be precise, of the total. However, given that the new notes are also higher value denominations, of ₹2,000 and ₹500 that do not contain better security features, whatever little benefit this move might accrue will not last very long. Given that the cost to clean up ₹400 crore of fake money may run to more than ₹12,000 crore, it's hard to comprehend the rationale.

"Black money" is not necessarily largely in cash. Tax raids from 2012-13 prove this point, as only 6% of the undisclosed income is in the form of cash.

Offsetting the minimal benefits are huge practical problems in implementation. The government's ill-preparedness, which might be due to the secrecy that had to be maintained, is not inspiring confidence. Basic logistical issues ranging from reconfiguring two lakh ATMs, to how to cater to rural agricultural folks through cooperative banks,to constraints in printing capacity highlight things were not adequately planned.

As of 16 November, more than 30 people lost their lives as a direct result of this currency chaos, while millions others — especially the poor — are enduring tremendous hardship on a daily basis. The trickle-down effect ensures that the poor, more so those in the rural places, will get the new money the last. And while the Supreme Court refused to intervene in the government's economic policy, it did urge the Centre to take steps to alleviate the suffering of people.

Researchers in any socioeconomic divide know this golden rule: "Reaching the poorest of the poor was (is) going to be the most difficult of challenge." As expected, a crisis has engulfed the nation, and the poorest are bearing the brunt of it.

The question of effectiveness

While the IMF and EU have welcomed the move, economists with first-hand understanding of the menaces, like India's former central bank governor and former chief economist of IMF, Dr. Raghuram Rajan and World Bank's Chief Economist and former Chief Economic Adviser of Government of India, Dr. Kaushik Basu, have expressed their reservations about the effectiveness of the demonetisation drive.
Here are some questions worth asking.

1. How much of individual wealth is in cash?

According to New World Wealth (2016), the individual assets of Indian citizens are estimated to be worth around $5,600 billion. This includes all asset classes: land, homes, gold, money stacked overseas, stocks, bonds, bank balance, cash, etc. Roughly $255 billion of this wealth is in cash.

2. How much cash is in ₹500 and ₹1000 notes?

Roughly 86.4%, meaning around $220 billion is in ₹500s and ₹1000s.

3. How much of the individual average private wealth, at the national level, is held in high denomination currencies?

Around 4%.

While we can acknowledge that cash is essential to lubricating the economic wheel, licit or illicit, "black money" is not necessarily largely in cash. Tax raids from 2012-13 onward prove the above point, as only 6% of the undisclosed income is in the form of cash.

To clean approximately 6% of the cancer, a carpet bombing has been carried out with collateral damage in the form of poor people. What's ironic is that records of Indian governments, current and past, have not shown any consistent seriousness in dealing with the real "big fishes".

Skill-building, not shocks to the system, for financial inclusion

Any bid for financial inclusion needs to tackle not only accessibility and affordability, but also skill-gaps and capacity building. Any socioeconomic divide (rich-poor, educated-illiterate, or even plastic-cash) has three key root causes: affordability, accessibility and skill level. The last part takes time, and is probably the most difficult.

In the last census, 67% of urban households and 54% rural households were "formally" covered within financial inclusion, but not necessarily "operationally" covered.

Now, the Pradhan Mantri Jan-Dhan Yojana (PMJDY) did something that should have been done long back — it is a huge financial inclusion programme designed to cover the large section of the population that has so far been removed from the formal banking network. However, laudable as it is, has the PMJDY indeed changed the habits of those it covers in any significant way? Are those accounts operational, or are they only numbers, mostly?

Three RBI data points — of ATM transactions in August 2016 (latest available), January 2014 (incidentally, when the ruling party was against demonetisation) and June 2011 — bring to light the fact that although there has been a huge increase in number of debit cards outstanding between January 2014 and August 2016 (87%) compared to June 2011 and Jan 2014 (58%) periods, the growth in value of ATM transactions (in debit cards, at ATMs alone) has slowed down significantly — to 27% from 56% respectively, for the two corresponding periods.

Including all cards (credit + debit), and including POS transactions (+ATM), this slowdown in growth in value of transactions is again visible — to 35% in January 2014—August 2016 from 61% in the June 2011—January 2014 period. (Note: While interpreting the data, the lower base effect for the starting month, June 2011, should be acknowledged.)

The above data answers the question on PMJDY numbers vis-a-vis users' behaviour — much of the new bank accounts and debits cards from the PMJDY have not resulted in a corresponding increase in the value of card-based (credit and/or debit) or ATM and/or POS transactions.

Changing user behaviour is not easy! A daily-wage earner, if s/he spends a day at a bank, misses his/her daily wage. Using an ATM needs some skills — many in India still do not feel comfortable with debit cards/ATM machines, as they do with mobile phones. The government's demonetisation move is likely to multiply the sufferings of this section of people. In the last census, 67% of urban households and 54% rural households were formally covered within financial inclusion, but not necessarily operationally covered.

The only long-term benefit from the demonetisation drive is that those who were not using their PMJDY accounts will now do so, while those who did not have accounts will now open them. However, this capacity building should have been done gradually, over a period of time. It is akin to throwing someone who doesn't know how to swim into deep water in the hope that fear will teach them how to stay afloat.

Justifying the huge pain of the common citizen for other collateral benefits, be it in the liabilities side of the balance sheet of the Central Bank (possible reduction of 10-15%) or in the deposit growth of the public sector banks, is premature and improper in every policy-making sense.

A version of this article first appeared in Counter Currents.

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