January 16, 2017    6 minute read

Demonetisation: The War On Cash

Hidden Motives    January 16, 2017    6 minute read

Demonetisation: The War On Cash

This is a world as unequal as it gets as far as distribution of wealth is concerned. Financial institutions are becoming more powerful each day, especially in developed economies. This trend is now shifting towards developing economies, and got a major boost when India’s Prime Minister Narendra Modi declared his “war on black money”.

A War Against Corruption?

Demonetisation is a radical monetary step in which a currency unit’s status as legal tender is declared invalid. This is usually done whenever there is a change of national currency, replacing an old unit with a new one. The best example in recent history is that of the euro. The European Central Bank prepared for almost three years with everyone fully knowing about the change on a particular day.

Banks and cash machines were front-loaded with new notes in advance. The European example shows how much advance preparation is needed just to maintain trust in legal tender. In India’s case, there was total chaos everywhere, from banks to cashpoints, from railway stations to hospital, from government institutions to private ones.

Worst of all, the Government has been coming up with new rules every day, creating more panic in the market, and daily life is slowing but surely coming to a full halt. The narrative that has been put forward by the government for the move is a need to curb the menace of black money and fake notes by reducing the amount of cash available in the system. If the Government’s case is that the high-value denomination currency is used to hoard black money, then the decision to reissue new 500 and 1000 rupee notes does not make sense.

94% of cash in India is estimated to be legitimate

In the last five years, IT raids have suggested that only 5-6% of India’s currency supply is in black money, so why is it that those who own the remaining 94% white money have to stand in line for the banks and ATMs? Is there something behind the picture which the Government is trying to hide, in the name of its “war on black money”?

The Big Picture: NPA And Bad loans

Earlier this summer, a Fitch rating report, which analysed banks with outstanding hybrid capital instruments, showed that the total capital adequacy ratios (CAR) of eleven Indian banks were lower than the minimum 11.5% required for the end of the 2019 fiscal year. Of the eleven, six banks did not even hold enough capital to meet the 10.25% required by the end of the current (2017) fiscal year, and ten of the eleven banks under risks are state owned.

banks_bad-loan2

Source: Reserve Bank of India

The capital adequacy ratio is the key indicator of a bank’s capital risk exposure. It indicates the amount of losses that can be absorbed by the bank. State-run banks in India constitute around 75% of the of the banking sector, and the report showed that their assets were in danger of breaching capital requirements, due to the bleak prospect of raising fresh funds as well as repaying loans. The gross non-performing assets (NPA) of the Indian banking sector stood at 6.5 trillion rupees.

So India’s banking sector was facing systematic failure risks, with problems with liquidity, bad loans and NPA (non-performing asset), which needed serious attention from different stakeholders like the government, the central bank and other institutions. There were two options for the government to get rid of such critical, systematic risk before the system falls apart. Either India’s at-risk banks default on their debt or pay it down.

The astonishing fact is that the ten top corporate groups owe significant amounts to state-owned banks and financial institutions. The current government lacks the will to chase those big heavyweight defaulters and seize their assets. The other way around the problem would be to nationalise the debt by scrapping the legal tender.

The cash demonetisation policy has provided the state-run banks with a large, much-needed base of low-cost deposits (solving the liquidity problem) and huge treasury gains at the cost of the common saver.

The War On Cash

The case for fighting black money and tax evaders has been overstated, especially for developing economies like India. A recent UK government survey conducted on money-laundering and terrorist-funding found that regulated institutions such as banks, and accounting firm providers like Mossack Fonseca posed the highest risk of facilitating the illicit storage or movement of funds.

Cash came third in the risk ranking, but if one applies the same rationale to India’s predicament, it would only make sense if banks and accounting firms had been banned first. Cash empowers people to buy and sell, and store their wealth, without being dependent on anyone else. It allows for legitimate transactions to be executed quickly, without either party paying fees to a bank or completing paperwork.

Cash also gives opportunities for vulnerable sections of society to participate in the economy without maintaining a bank account. India is one of the most cash-dependent economies in the world, with a cash-to-GDP ratio almost four times that of fellow BRICS countries. Modi’s utopian vision is of a cashless society for a country in which one-quarter of the population, as well as the 80% of women who do not have a proper bank account, would not be able to meet its basic necessities.

A Dangerous Vision

A cashless society would not be a boon for countries like India, but a burden too heavy to carry. An inclusive financial approach without proper social inclusion will always remain a dream. Modi’s vision will only empower the so-called “money-changers” and bankers, at the cost of common individual financial freedom.

A cashless society would allow bankers to have more influence in setting the country’s monetary policy and its economic agenda, as has happened in the West where governments seem likely to first ban cash and then implement negative interest rates just to protect big banks.

The vision of a cashless society comes at the very tangible cost of one’s individual liberty and future prosperity. The question for common Indians is whether they are willing to pay that price.

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