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Demonetisation Is Modi's King's Gambit, And Black Is Losing

22/11/2016 10:49 AM IST | Updated 25/11/2016 8:36 AM IST
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A cashier counts bank notes at a bank in Allahabad, India. (AP Photo/Rajesh Kumar Singh, File)

The Indian government's demonetisation exercise has shaken up the country's economic and political system. On the day of the American elections on 8 November, Prime Minister Narendra Modi announced that the current ₹500 and ₹1,000 notes would be invalid by midnight and that the citizens needed to replace their current notes by depositing them in banks by 30 December. The impact of this decision — considered one of the most profound steps in India post-independence — is enormous.

This move is a game changer in enabling financial inclusion at a far more rapid pace and also moving towards a "cashless" economy...

India, according to this report, "has one of the highest levels of currencies in circulation at over 12% of gross domestic product" and 87% of this is in the form of ₹500 and ₹1,000 notes; approximately 80% of this money is in the informal economy. The fact that a large part of the informal sector's transactions have been in cash has helped perpetuate corruption, since it is never disclosed to the tax authorities and is circulated as "black money". According to Global Financial Integrity, $60 billion of black money outflow happens from India every year. (To put this into context: the defence ministry's budget in India is about $50 billion per annum!) According to estimates, 80% of the black money in cash is in denominations of ₹500 and ₹1,000. By making these denominations invalid without notice, the Modi government is dealing a blow to the black money market, while also laying a trap for hoarders as they are obliged to deposit their money for it to be ever usable.

This move has been criticised on many counts, but in the following paragraphs I will explain why these arguments do not hold.

Secrecy was essential

The primary criticism by the political opposition is that the government took a unilateral decision without giving people enough time to prepare for the change. However, this secrecy was essential for the effectiveness of the move — the point was to catch black money hoarders, especially the political class which relies on black money for elections, off guard. Had Prime Minister Modi shared the move with even his own Cabinet members, it might have thrown a spanner in the works and black money hoarders might have been tipped off and converted their currency to "safer" assets. However, to the government's credit, it also informed the people that "action" would be taken after the 30 September amnesty deadline for tax evaders as part of the income disclosure scheme. The government had hinted earlier that it was serious about tackling black money. This was the best it could practicably do before taking this decisive action.

The inconvenience is only for the short term

The second criticism of the demonetisation effort is that it is causing unnecessary inconvenience for common citizens, particularly those in rural areas who do not have a bank account. Here, it is pertinent to note that in the integration of the Pradhan Mantri Jan Dhan Yojana and Aadhaar schemes, more than 1 billion unique IDs have been created and bank accounts have been opened across India. According to the Intermedia Financial Inclusion Report 2015, more than 75% of Indians earning $2.5/day or more have bank accounts. This number has accelerated in the last one year, considering that almost every Indian has an Aadhaar number. As such, most Indians even in rural areas have bank accounts and can now start to actively use these.

The key to solving the black money puzzle is to enable better tracking mechanisms once the new notes are circulating in the market...

In addition, this also is a game changer in enabling financial inclusion at a far more rapid pace and also moving towards a "cashless" economy which has been the goal of the government and the RBI for a few years. The RBI's concept paper On Card Acceptance Infrastructure in March had noted the lack of an ecosystem of electronic payment mechanisms in smaller towns and rural India and this demonetisation move could be the trigger to change the scenario.

A much-needed "reset"

The third criticism has been on the ability of the move to completely eliminate black money from the country and if it was worth all the inconvenience caused. Most argue that the illicit money could be converted to gold instantly by black money traders. In an attempt to counter this narrative, the government has sent income tax notices to all jewellers in the country to provide an account of their transactions during this period. While it would be gullible to think that demonetisation could eliminate all black money, what this move does do is provide an opportunity to "reset" the flow of money; more importantly, it creates a perception that the government is watching and is intent on eliminating black money. The key to solving the black money puzzle is to enable better tracking mechanisms once the new notes are circulating in the market, and thus set the stage for complete eradication in the short and medium term.

Evolution to a less corrupt and "cashless" economy

The last criticism by some economists is that this move will cause a liquidity squeeze and that it would create deflationary effects for the economy. I think everyone agrees that it will take some time for the economy to adjust to these changes, but India's evolution to a less corrupt and cashless economy will be lucrative in the long run. Companies such as Paytm and the plethora of payment banks coming into the system via the Unified Payments Interface (UPI) ensure that the liquidity squeeze in the short term can be compensated by a substantial consumption drive in the medium term with a digital monetary system in full flow. This would counter the deflationary trends in the short term and ensure that the interest rates are competitive and the common citizen isn't getting affected. In addition, the infusion of money into the banking system enables greater liquidity in the months ahead which is a very good prospect. For example, the State Bank of India, India's largest public sector, gained ₹53,000 crore in new deposits in just two days after the announcement. The financial integration generated through these deposits would serve the economy well in the medium to longer runs and counter the criticisms expressed by some economists.

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In totality, this move by the Modi government is seen as being as important as the 1873 demonetisation of silver by the United States due to its magnitude of impact on the economy. The demonetisation drive hits three targets with one stone: it catches the black money traders off guard and causes a stop in the flow of such cash; it promotes financial inclusion across the country, enabling greater bank access and digital financial transformation; and it also roots out corruption with the popular will of the people. Not only does this create awareness but signals a tectonic shift in the approach to transactions. It also triggers the government to build superior infrastructure to enable this process. No one is denying the temporary inconvenience in the weeks ahead but the above mentioned benefits far outweigh the short-term inconveniences. In this context, it's a King's gambit well worth taking.

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