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Demonetisation: One Year After

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The performer’s boldest stroke

ON NOVEMBER 8TH last year, Prime Minister Narendra Modi made a dramatic announcement. In one go, he outlawed notes of Rs 500 and Rs 1,000 that constituted 86 per cent of the country’s currency in circulation. It was perhaps India’s boldest policy experiment in over a quarter century.

A year later, a paradox of sorts has emerged: while intellectuals and analysts in India have slammed the step, Indians at large have reacted positively to it. The usual explanation is that the economics and politics of demonetisation bear no connection, with the idea finding favour with citizens by virtue of the populist appeal of its moral logic. Lost in the noise are the modernising features of a larger process that began with creating no-frill bank accounts for the underprivileged and has culminated—for the time being—in a major tax reform, the Goods and Services Tax (GST).

In the weeks and months after November 8th, 2016, Indians cutting across all lines—rich and poor, urban and rural—formed serpentine queues to deposit money and get hold of some precious but rationed cash for much-needed daily use. In a country whose economy was dominated by cash transactions, demonetisation was a drastic attempt to change the behaviour of Indians, moving them away from the use of currency notes towards electronic modes of transferring money. It was also an attempt to check black money by imposing what economists called a ‘one-time shock’ that would neutralise it.

The initial days after the announcement were chaotic, as expected. This was no surprise, since currency worth an estimated Rs 15.4 lakh crore had been expunged as legal tender and remonetisation would take time. The opposition smelt an instant opportunity in the disruption caused by the event, and began to forecast doom and gloom for the country. Critics said that Indian voters would exact vengeance from the ruling Bharatiya Janata Party (BJP) for this act of large-scale ‘destruction’ visited upon them. That claim continues to be made even today, though the political effect on the opposition of their protests has been less than salutary.

Twelve months past, those queues are mostly a faded memory, the country has been remonetised adequately, and other policy measures such as the GST have been implemented by the Modi Government. But a few voices against the move remain as loud as ever. Some criticisms have been pertinent, others merely petulant. The one with the strongest force was of the badly handled remonetisation of the economy. This argument could be made with a simple illustration. Suppose a country uses 70 per cent of its currency for transactions—buying and selling goods—and uses the rest as a store of value. Surely, it is important to smoothly replace old stock with new? Even if one assumes a further 20 percentage point reduction in the use of notes—say, people shift habits and start doing online transactions—that still leaves a 50 per cent requirement for new currency almost at the word go. This need took painfully long to be met.

THE TRANSITORY ECONOMIC consequences of it were felt in the slowing of growth in the two quarters right after demonetisation. In the last quarter of fiscal year 2016-17, the rate of GDP growth fell to 6.1 per cent, compared with a figure of 7.9 per cent in the same quarter of 2015-16. An even worse number awaited the country for the first quarter of fiscal 2017-18, when growth fell to 5.7 per cent compared to 7.1 per cent in the same quarter of the previous year.

Once those figures of decline were placed alongside a drop in the prices of agricultural commodities earlier this year, critics dashed off to declare demonetisation dead in the water. In Uttar Pradesh, potato prices fell to just over half of what prevailed in 2016. Something similar happened with farm-gate prices of tomatoes and onions. This led to farmer unrest across states such as Madhya Pradesh, Rajasthan and Maharashtra. Soon this turned into generalised agrarian distress over mounting debts, and the lines between what demonetisation had done and what was due to long-running factors got blurred. Finally, trouble had to be staved off by political handouts, with several states announcing farm-loan waiver packages, a remedy not quite in consistence with the alleged initial ailment. In any case, most of these troubles were over by September this year. Of all the criticisms levelled against the November 8th decision, those that focused on an economic slowdown and the poorly executed process of remonetisation had the greatest weight.

The queues are now mostly a faded memory, the country has been remonetised adequately, and other policy measures such as the GST have been implemented by the Modi Government

What has much less credence is the charge that demonetisation has failed to ‘fix’ the country’s problem of black money. This is an exaggerated point that is not really as stark as it has been made out to be. Originally, the hope indeed was that a substantial fraction of the unaccounted-for stock of money would be ‘extinguished’ as people would be hesitant to deposit their ill-gotten funds in bank accounts. The initial idea of withdrawing Rs 500 and Rs 1,000 notes was to prevent the use of these as a store of illicit wealth. Soon after the move was announced, however, economists led by Jagdish Bhagwati pointed out that this may not pan out.

It did not. On February 1st this year, Union Finance Minister Arun Jaitley gave Parliament a set of figures for ‘high value’ deposits made within the period that banks were accepting old cash. The sums are staggering. Deposits exceeding Rs 80 lakh were made in 148,000 accounts with an average deposit size of just above Rs 3.3 crore. Similarly, smaller deposits, ranging from Rs 2 lakh to Rs 80 lakh were made in about 10.9 million accounts with an average deposit of just above Rs 5 lakh. Bhagwati and his colleagues estimated these deposits as accounting for over Rs 10 lakh crore in all, about two-thirds of the currency stock demonetised. If any doubt were left about how much cash came to light, the Reserve Bank of India’s Annual Report, released on August 30th, put an end to it. Of the Rs 15.4 lakh crore worth of high-value notes in circulation before the move, almost Rs 15.3 lakh crore had been returned to the RBI by June 30th, amounting to roughly 99 per cent of it.

Critics were quick off the gun and said this was the ‘last nail’ in the coffin of demonetisation.

At the very minimum, that is misleading. To begin with, the withdrawal of large-denomination notes was supposed to be a one- time strike on black money. That exercise is not yet over. A clear path to the goal would have been the instant extinguishing of cash that did not return to the banking system. But that path having closed does not mean there are no alternatives. As mentioned by the Finance Minister, the number of suspect deposits is very large. A combination of scrutiny by tax officials and the use of data-mining methods to spot irregularities is an option that is still open, one that the Government is unlikely to close. Of course, not only is it cumbersome, it also presents tough choices: hard-headed scrutiny is likely to result in complaints of harassment and victimisation at the hands of tax authorities. How the Government balances the twin objectives of unearthing black money and safeguarding innocents from mistreatment is something to watch out for.

The trouble with the ‘last nail’ critique is that it looks at demonetisation in isolation. In reality, for the Modi Government it was only one in a series of steps meant to modernise the Indian economy and reduce the corruption that has moved wheels in India for too long.

This has been acknowledged even by friends turned critics of demonetisation. One prominent example is Kenneth Rogoff, professor of public policy at Harvard University. Initially, he along with some other economists overseas had welcomed the move. Later, on witnessing the scale of what was planned and the logistical problems of remonetisation, Rogoff’s stance turned a little critical. More recently, in an afterword to the new edition of his book, The Curse of Cash, which appeared after demonetisation and just before the GST became operational, he writes: ‘Will India’s demonetisation yield long-term benefits? The answer, of course, depends on the implementation of other government policies to fight black money and corruption and how well it succeeds in accelerating progress towards financial inclusion. For example, India’s new gross sales tax (Goods and Services Tax) may make tax enforcement somewhat easier, and the government has been engaging in financial information treaties with other countries to make offshore laundering more difficult.’

The early benefits of enhanced transparency were already at hand in August this year when the government shuttered 163,000 companies across the country on the basis of data mined after demonetisation

Somehow that larger picture eludes most critics. It is one thing to examine demonetisation and correctly point out problems in its wake, and something entirely different to look at the series of steps that began with the creation of Jan Dhan no-frill accounts all the way up till the GST. If one casts an extended gaze on this sequence, a coherent pattern comes into view. Two specific shifts are clearly visible. One lasting legacy of demonetisation is the great speeding up of digital transactions. Even if there has been some return to cash once the scarcity period was over, the changed landscape is broadly here to stay. Payments via Real Time Gross Settlement (RTGS) and National Electronic Funds Transfer (NEFT) mechanisms are up by 6 or 20 per cent (depending on whether they are measured by the number or value of transactions) compared to 2016-17. The use of Prepaid Instruments or PPIs has gone up even more sharply. Much of this was, to use the language of critics, ‘enforced’ by demonetisation. But the semantics of it—whether you call it ‘enforced’ or a ‘nudge’—makes little difference. The point is that these transactions leave an electronic trail and are subject to scrutiny by the tax authorities if they so choose. Not only do transaction costs come down when payments are made online, they can be called up onto an official screen to be examined.

The early benefits of enhanced transparency were already at hand in August this year when the Government shuttered 163,000 companies across the country on the basis of data mined after demonetisation. Of these, nearly 38,000 were found to be shell companies—firms in existence not for business but financial deception.

Linked to all this is the second big problem that is now on its way to being solved. Since the advent of taxation in Independent India, vast numbers of self-employed individuals—businessmen, petty shopkeepers and traders among others—have managed to evade both direct and indirect taxes to a large extent. A cash-based economy made the expansion of the taxpayer base hard, if not impossible, in the absence of coercive methods being adopted. Some tough approaches were tried for a while in the 1970s but ended up being counterproductive. The overall result has been a low tax-to-GDP ratio that left little money for the Government to invest after meeting its expenditures. Now a combination of online transactions and the GST network has helped expand the taxpayer base. After the GST was implemented, taxes collected under it in September alone amounted to around Rs 92,000 crore (while input credit was also claimed for a large sum). For anyone who has observed the trend of indirect tax collections in the country, this is a positive shock. Barely ten years ago, in 2007-08, the total indirect tax collections in the country stood at Rs 2.76 lakh crore. If implemented well—and with the ironing out of its glitches—the GST promises to deliver what India needs: sufficient money in the hands of the Government to deliver the basic services that the vast majority of citizens have been deprived of.

PERHAPS ALL THIS explains the divergent reactions to these developments. At the level of political parties and their intellectual supporters, there is plenty of anger at what is happening. As mentioned earlier, one of the criticisms of demonetisation by analysts is plain wrong: the lingering effects of draining out cash have worn-off. If these had persisted, they would have shown up in the political domain, for no government can escape public wrath at a policy miscalculation on such a scale. In Uttar Pradesh, Assembly elections were held over a period of one month about a quarter after demonetisation. The BJP won hands down. Similarly, local body polls in Maharashtra a bit later saw the BJP take a leading position. In case the effects of the drain-out and travails of remonetisation were as acute as portrayed by critics back then, surely there would have been political reversals for the ruling party. There has been none so far.

Here again, Rogoff is perceptive. ‘Perhaps surprisingly, India’s demonetization, no matter how much criticized by economists, has been broadly popular in a country where people are deeply frustrated by endemic corruption, and appreciate the government’s broad efforts to fight it… Certainly demonetization has greatly accelerated financial inclusion, with hundreds of millions of Indians now taking advantage of heavily subsidized basic debit accounts, a program that until now, had been developing relatively slowly. There is little doubt that multitudes of papers will be written on India’s demonetization, but it could take years to untangle its full effects, which have as much to do with psychology as economics.’

Such analyses are best left to scholars, but even a cursory observation of the scenario one year after the event suggests that something is at work that has been left unexplored, or even ignored, in the plethora of commentary since then. Analysts and political parties have been quick to point out the suffering of people in India’s huge spread of villages, towns and small cities. The opposition even saw in it a chance of recovering political traction after the drubbing it suffered in the General Election of 2014. But nothing seems to have come of it at the electoral level, though there are admittedly many other factors at work in that arena. Still, the opposition appears out of sync with mass sentiment. So too are analysts who fail to appreciate the popularity of Modi’s agenda. While they were impatient and annoyed, most Indians displayed remarkable patience with the efforts of a government seen to be cracking down on corruption. Again, the answer may not be fully known unless deeper studies are carried out.

All said, it is a mistake to view bold policy experiments such as demonetisation in isolation of other economic steps and from political incentives that underlie the actions of ruling parties. In an intensely competitive polity like India, it is rare to see such policy- level aggression. The usual trend is for governments to carry out incremental changes, ones that opposition parties react to, or even copy, and the ‘window of opportunity’ created by minor political innovations—for example, welfare schemes hatched at the urging of non-governmental o\rganisations—then quickly close. To use the language of equity investors, there is little room for ‘political arbitrage’ in India. What Modi and his team have done is to open such a window that will not shut easily: Indians want an honest government and demand that the system deliver results. What happens in the future cannot be known, of course, but an attempt has been made.