February 15, 2017    7 minute read

India: Three Months since Modi’s Demonetisation

Withdrawal Symptoms    February 15, 2017    7 minute read

India: Three Months since Modi’s Demonetisation

On November 8th, 2016, the same day that Donald Trump was elected US President, Indian Prime Minister Narendra Modi announced his demonetisation scheme: the removal of the 500 and 1000 rupee notes from circulation. The stated aim of the policy was to rid the system of black money (undeclared money that has not been taxed), forcing hoarders to either deposit their cash and be taxed, or lose the entire amount.

These Specified Bank Notes (SBNs), which made up about 86% of all cash in the country, became mere pieces of paper. The notes could be deposited in bank or post office accounts between November 10th and December 31st, 2016 without any restrictions and, just as before, cash could be withdrawn when needed.

86% of India’s cash was in 500 and 1000 rupee notes

In the first instance, a withdrawal limit of 10,000 rupees per day and 20,000 rupees per week would be put in place to regulate excess demand. Cash machines would be closed on November 9th, or November 10th in some places, to allow for re-stocking. Alternatively, SBNs could simply be exchanged at any bank or post office for immediate use, with a limit of 4000 rupees per day.

The old notes would, however, continue to be accepted for 72 hours at government hospitals, crematoriums, and government-authorised co-operative stores and fuel stations. Provisions were also put in place for tourists exchanging foreign currency.

Demonetisation and the RBI: Undue Influence? 

One of the basic assets of central banking is independence from government. It insures against the monetisation of debt, hyperinflations, and monetary policy being influenced by potential short-term political gains.

An RBI briefing to parliament in December, said that on November 7th, 2016, the government had “advised the Reserve Bank that to mitigate the triple problems of counterfeiting, terrorist financing and black money, the Central Board of the Reserve Bank may consider withdrawal of the legal circulation status of the notes in high denominations of Rs.500 and Rs.1,000.”

The Central Board met the next day and, following discussions, decided to recommend the scheme. It was clear from the outset that the policy would be implemented and the government was simply asking for the recommendation as a formality. It seems as if this trend of government interference in monetary policy is set to continue at least throughout governor Urjit Patel’s reign if not through all of Modi’s.

Interestingly, it does shed some light on ex-governor Raghuram Rajan’s reasons for not renewing his contract. There were already rumours of Rajan’s discontent at Modi’s influence on the RBI, and his recent criticisms of the policy only added fuel to the fire.

It was also revealed recently that a few top government officials had secretly begun working on the plan six months before the announcement. Since Rajan only declared his intentions in June and Patel was only appointed in August, this confirms that the initial decision was taken without any RBI initiative.

India’s Cash Crunch Bites

The first couple of weeks were chaotic. There were serpentine lines outside cash machines and bank branches, with cash often running out before everyone had withdrawn or exchanged their money. Stories emerged of deaths whilst waiting in line, suicides, burning sacks of old SBNs and other bizarre and heartbreaking incidents.

Many people in rural India had to travel for hours to reach banks and often left without being able to withdraw their own hard-earned money. The policy even came under criticism from economist Kenneth Rogoff, who has been in favour of demonetising high-denomination notes for many years. He suggests a phasing out over five-seven years, claiming Modi’s move simply caused too much collateral damage.

In January, the International Monetary Fund (IMF) downgraded its growth estimate for India from 7.6% to 6.6% for the 2016-2017 fiscal year, and from 7.6% to 7.2% for the following one. The World Bank similarly downgraded its forecast from 7.6% to a “still robust” 7%. Both estimates are in sync with the Indian Ministry of Statistics’ prediction that growth will slow to 7.1%, from an originally expected 7.6%.

The Unorganised Sector: India’s Shadow Economy

Thus it seems the Indian economy is expected to swiftly deal with the cash crunch, and revert back to its story of impressive growth. However, as with any other emerging economy, accounting for growth is made significantly more complex by the disproportionately large size of the unorganised sector.

The unorganised sector in India refers to those economic agents and enterprises that are generally of uncertain legal status, in labour-intensive work, with low job security and often receiving low compensation. According to a 2005 report by the National Commission for Enterprises in the Unorganised Sector (NCEUS), approximately 86% of India’s employed work in the unorganised sector, generating 50.6% of the country’s GDP.

50.6% of India’s GDP is generated in the unorganised sector

This is a striking statistic that to an extent implies that as long as the 14% in the organised sector are chugging along, India’s GDP should do the same.

The withdrawal of legal tender status from the SBNs will undoubtedly affect those people and businesses that do not have guaranteed availability of technological infrastructure or easy access to banking. Add this to the struggles of documenting the unorganised sector in the first place, and it is safe to say that growth estimates are unlikely to reflect the demonetisation’s real economic impact on the Indian people.

Will It Work?

Most black money is not in the form of cash under mattresses. In fact, most estimates say that cash accounts for only 6-10% of it. Significant amounts of undeclared income, whether legal or not, are reinvested in gold, silver, real estate, and other durable goods where buyers often enjoy substantial cash discounts.

One of the biggest issues facing the Indian government is how to get tax evaders to consistently pay tax. After all, with the new notes being brought into circulation, there is little reason why those who previously hoarded cash will not do so again. Furthermore, the risk of another episode of demonetisation in the near future is virtually non-existent.

The Near Future

Fortunately, India is doing well in this regard. Through his charismatic personality, emotional speeches, and strong leadership, Modi has fostered a new sense of patriotism in the country that has not been seen since the early days of independence. The most startling example of this is the widespread support for demonetisation amongst the population – even those being hit the hardest.

By asking people to stay strong and persevere with the policy for a better future, Modi has successfully appealed to the Gandhian principle of sacrifice that most Indians hold sacred. This breed of patriotism is very different to the kind coming to prominence in the West, in the sense that it does not intend to protect the country from the external forces of globalisation but simply improve conditions internally.

10%the percentage of black money affected by demonetisation

Whatever the opinion of renowned economists, the move is already a success in the minds of most Indians. Though the disruptive policy seemed a peculiar method of targeting only 10% of the black money, the last 50 days of 2016 will be seen as the first major crackdown on tax evasion in India.

The government’s plan of action now must be to bring transparency in real estate and jewelry markets, tax the huge sums of money stored in Swiss bank accounts, and, most importantly, ensuring the speedy adoption of electronic payment systems and bank accounts and the smooth circulation of cash to those caught in the crossfire in the war on corruption.

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