In the recently concluded US Presidential elections, millions of Americans voted against Hillary Clinton because, among other reasons, they believed she would increase taxes or otherwise ‘take their money’. While the whole world sat glued to the developments unfolding in the US, most didn’t notice what transpired on the other side of the world that very same day. The Indian Prime Minister Narendra Modi literally did take everyone’s money.
Indians learned, with only a few hours’ notice, that their 500 and 1,000-rupee notes were no longer legal tender. Those are—or were—India’s largest-denomination bills and the underpinning of a huge underground economy. Prime Minister, Narendra Modi, in his November 8 2016 televised address, announced demonetization of India's 500 and 1,000-rupee notes, which made up 86 percent of the country's currency.
It has been given to understand that the change was undertaken to confront the problem of black money, terrorism and the informal economy that escapes taxation by bringing the cash holdings of citizens into the banking system, where it couldn’t easily avoid detection, and by making the cash that didn’t enter the system essentially useless. The plan indeed seemed so simple and bold and brilliant, and the Indians just lapped up the idea.
One Hell of a Moment
In a flash, billions of currency notes suddenly became unusable. They, of course, shall retain their value until the end of 2016, but the only way to use them is by going to the bank and exchanging them for smaller notes, up to a limit of 4,000 rupees! People may also deposit them in bank accounts and then use a debit card or electronic transfers for purchases. While the idea sounded pretty simple, it quickly turned into a monumental mess. Queues formed at banks, with people waiting for days, only to find the bank ran out of smaller bills. Those without bank accounts had no way to make routine transactions. The underprivileged had to spend their work time waiting to exchange their money. New bills intended to replace the old ones were scarce. The results spread through the economy like wildfire. Merchants lost sales because customers couldn’t pay. Some resorted to barter. Media reports suggest restoring normal commerce could take months. A few people reportedly died, most of them elderly citizens waiting outside banks for days, but also some overworked bank employees.
The demonetization plan has laudable aims. Its initial popularity was based on the idea that the greedy rich, with their ill-gotten “black money” stored in stacks of banknotes, will get their comeuppance. Those who cannot justify the sources of their wealth will face punitive taxes. It also accords with Mr Modi’s manifesto pledge to normalise India’s black economy, estimated by the World Bank in 2010 to be worth about one-fifth of official GDP. The idea is that India will become more efficient, as more people and more money enter the banking system; counterfeit currency will become worthless; India’s woefully low tax base will expand; and government coffers will enjoy a windfall of cash expropriated from the corrupt. The government's sudden decision to withdraw large-denomination currency from circulation, has however caused enormous hardship to millions of people in the country's predominantly cash-based economy. While, holders have until the end of the year to deposit them in banks or swap them, either for smaller-denomination notes or for new 500- and 2,000-rupee ones, shops across the country have stopped accepting the old notes at once.
Past Experiences and the Present
India is not the first or only country to introduce abrupt, drastic reform of its currency. But the precedents—including Burma in 1987, the former Soviet Union in 1991 and North Korea in 2009—are not encouraging. Burma erupted in revolt, the Soviet Union disintegrated and North Koreans went hungry. The November 8 ban on high-value currency notes has sent India's economy into a tailspin, as citizens struggle to get their hands on new bills, hindered by a limited stock of freshly-printed notes, daily account withdrawal restrictions, long queues at banks and empty ATM machines. Cash is used for 98% by volume of all consumer transactions in India. With factories idle, small shops struggling and a shortage of cash to pay farmers for their produce, the economy is stuttering. There are reports that sales of farm staples have fallen by half and those of consumer durables by 70%. Guesses at the effect on national output vary wildly, but the rupee withdrawal could shave two percentage points off annual GDP growth (running at 7.1% in the three months to September).
With farmers unable to buy seeds and roadside shopkeepers unable to sell produce, the low-income population has emerged as the biggest losers from the milestone policy designed to stamp out so-called "black money." Low-income earners are among the nation's most cash-reliant because many lack bank accounts or the required identity cards, so they are ineligible to swap notes for smaller denominations. They're also particularly vulnerable to the overall drop in consumer spending because their livelihoods tend to be more dependent on cash transactions.
Likely Fallout
Cash is the primary mode of transaction in agriculture sector which contributes 15% to India’s total output. Formal financing in many parts, especially Punjab, Uttar Pradesh, Odisha, Maharashtra, Gujarat and Kerala is significantly from cooperative banks, which are barred from exchange-deposit of demonetized currency. Notably, this is a time of kharif harvest and start of rabi sowing, partly explaining why this period is dubbed the ‘busy season’ from a standpoint of credit demand, the other being bunching of festivals and weddings.
Winter crops such as wheat, mustard, chickpeas are due for sowing in a fortnight. Wheat prices were already up due to low stocks and anticipated shortfall in 2015-16 output and have firmed up further as demonetization fallout pushes traders to build more inventories. Production in 2016-17 could drop if sowed acreage (rabi) reduces for want of enough seeds on time to exploit the adequate soil moisture. Yields could fall from late sowing and subsequent exposure to rough spring weather, the lack of sufficient or timely application of fertilizers, pesticides, etc. Farm labour, vital for this period, is reported to be unpaid as farmers have no cash. Many of them are reported to be returning from some northern parts to homes in UP and Bihar. Labour shortages and wage-spikes may follow with a lag.
Plantation crops such as rubber, tea, jute, cardamom are seeing no wages paid to workers. Small-medium tea growers have few buyers now (a third of the tea was unsold in recent auction in the south). Raw jute trade is halted as paucity of funds affects procurement-delivery by traders. Cotton is witnessing havoc: daily arrivals have plunged to 30,000-40,000 bales against the usual 1.5-2 lakh bales at this time (harvest) as per reports and prices have soared 9% in a week, pushing up global prices in turn.
What do the Experts Say
While proponents of demonetization recognize that demonetization could yield higher government revenues and produce greater public goods, such as improved infrastructure, but famous economists like Larry Summers, have warned of a greater negative impact from poor execution. Summers is former U.S. Treasury Secretary. "The costs (of demonetization) exceed its benefits," he said. Economists at Ambit Capital cut their 2017 GDP growth estimate almost in half, from 6.8% to 3.5%. They think the effects will last into 2018, too.
Is it Right to Punish an Entire Village to catch a Few Thieves
Prime Minister Modi however says that restricting cash (he calls it “demonetization”) will help boost the economy. Maybe it will. Estimates show anywhere from 25–40% of India’s economic activity happens off the books. Bringing it out of the shadows and into the banking system, even by force, may help in the long run. It will certainly raise tax revenue initially. But it also carries a big cost.
While plenty of Indians do use cash transactions to hide their wealth and avoid taxes — less than 3 percent of the population pays income taxes — and the authorities occasionally arrest businesspeople or corrupt officials with currency hoards. But plenty more people use cash because of habit, poverty or a lack of easy access to banks. This explains the disproportionate impact of demonetization on the middle and lower wage classes. It is the derailment of the latter’s lives caused by the demonetization that has caused many to write that the policy is a failure — and others to go so far as to call it a criminal injustice.
The informal economy in India is estimated to employ 94 percent of India’s labor force and covers large parts of the country. The informal economy does contain the black market and can lead to trade of illegal or questionable goods, but it sometimes simply involves farmers or low-wage workers and local rural economies. In those situations, cash transactions are not a method of circumventing the government but rather the only practical means of exchange among those without access to banking, whose livelihoods are small, irregular and/or best suited for an informal setting without regulations. Taxing the informal economy is one of the government’s aims.
While around 85% of all currency in circulation has been turned into coupons that can only be exchanged in specific places; these notes can be converted into currency again only with identity proofs (which hundreds of millions do not have) notwithstanding the additional hardship of standing in queues for many hours. Over half of India’s population doesn’t have any sort of bank account at the moment and about 300 million don’t have basic ID such as Aadhaar either and hence, cannot access the banking system at all. About 130 million Indians have mobile wallets, about 25 million have credit cards and there are about 550-600 million debit cards in circulation. So access to cash is very, very important for those Indians who are unbanked, and limited by their access to mobile wallets. As India's poor pay the heaviest price for Prime Minister Modi's bold demonetization move, many warn the current pain could eclipse long-term benefits. Meanwhile, the Supreme Court of India has asked Modi's administration to file an affidavit detailing the steps being taken to ease the inconvenience to the general public.
How legal is this move?
Another question that has surfaced of late in the legal corridors is to what extent was the demonetization consistent with the statutory provisions in Chapter III of the Reserve Bank of India (RBI) Act 1934, which assigns to the RBI the sole right to issue currency notes under Section 22? The right to determine the denominations in which currency notes are to be issued, and the rights of non-issue or discontinuance of particular denominations, are assigned in Section 24 of that chapter to the government, subject to the recommendations of the central board of the RBI. The recommendatory authority of the central board is paramount, as stated in the Act. Discontinuance is not equivalent to cessation as legal tender, and usually carries a long phase-out period. Cessation as legal tender is dealt with in Section 26, reproduced below. It (Section 26) also accords primacy to the central board of RBI.
“On recommendation of the Central Board the Central Government may, by notification in the Gazette of India, declare that, with effect from such date as may be specified in the notification, any series of bank notes of any denomination shall cease to be legal tender.”
Note the wording, which speaks of the cessation of particular series of bank notes as legal tender. Neither the provision for discontinuance, nor that for cessation, visualizes the withdrawal of all series of an entire denomination without full replacement against other valid denominations. Every currency note carries a formal promise to redeem (pay) in full its face value, signed by the RBI governor. The authority of the RBI governor to give such a guarantee is backed by powers vested in him by the central board of the RBI. The statutory responsibility for upholding the guarantee underpinning paper currency is vested with RBI’s central board. That responsibility would have been fulfilled only if replacement currency was stocked and fully available at any of the several surrender nodes for demonetized currency in this vast country. An emergency meeting of the RBI central board is reported to have been held on the evening of 8 November. Even if the board was trying to be a team player by going along with what the government wanted to do, why would they recommend turning Rs500 and Rs1,000 notes into pumpkins at midnight, without checking if replacement currency was in stock?
It was the absence of preparation with replacement currency, well-stocked banks and functional ATMs that turned this into an unmitigated disaster, rather than the suddenness of the change. A forward effective date known only to the RBI governor and the government could in principle have been kept secret. Even the board did not need to be informed in advance, while currency stocks were being prepared. After the announcement, currency printing went into overdrive in a manner that clearly shows the RBI was a follower, not in the know, of what happened.
What if the central board had refused to go along until replacement currency was fully in place? Section 30 of the RBI Act does give the Union government the power to supersede the board. But in such an exigency, the government has to place before Parliament an explanation of the circumstances under which the suppression was done, within three months. All the expected gains of this action, such as the additional income tax revenue from stocks of currency deposited in banks, would have accrued even with a 50-day preparation period for demonetization. The advantages of going without preparation of replacement stocks are therefore altogether unclear.
How Short Term are the Collateral Damages
The costs of demonetization are not merely short-term. Much of the un-taxed wealth in this country is not held as cash or jewelry. It is turned into income-earning financial assets through loans to small businesses. Some of the largest commercial construction companies borrow from holders of big stocks of cash on the thriving informal market. If not converted into a financial asset, cash is typically spent on housing and house renovation, weddings or tourism. Construction, weddings and (domestic) tourism are the most employment generating activities in India. The impact of demonetization will therefore be not merely to reduce growth but to pull down the employment elasticity of growth, until activity in these sectors picks up again. Finance minister Arun Jaitley, responding to a question at a press conference recently, has however ruled out any short-term impact of demonetization on growth, holding that it will rather benefit growth in the long run because “all this will impact the size of the GDP itself because more transaction that were happening outside the (formal) economy will get into the economy itself”.
Over the past month, since November 8 2016, however, there have been several accusations that the policy’s intentions weren’t those that were sold to the public — that it was a move to cripple political opponents, to make Prime Minister Modi appear stronger, to inconvenience the middle class while the rich stashed their black money in Swiss accounts.
While building a country, the long run does matter — and that is why people chose Narendra Damodardas Modi in his landslide victory in 2014. We do need big ideas, bold moves and the audacity to hope. But that doesn’t justify this kind of policy initiative, which writes off the suffering of millions as collateral damage when that suffering could so easily be avoided.
References:
http://marginalrevolution.com/marginalrevolution/2016/11/indias-demonetization-next.html
http://www.technavio.com/report/mobile-wallet-market-in-india-2014-2018?utm_source=B3&utm_medium=TNSite&utm_campaign=Blog
http://www.stanforddaily.com/2016/12/02/indias-demonetization-and-the-future-2/
http://www.livemint.com/Opinion/B1vFTOgwqHjdM5nkmg2CxJ/Demonetization-The-impact-on-agriculture.html
http://www.economist.com/news/leaders/21711040-narendra-modi-needs-take-measures-mitigate-damage-his-rupee-reform-has-done-indias
http://www.cnbc.com/2016/11/22/indias-demonetization-drive-to-help-dictate-bjp-modis-fortunes.html
http://www.forbes.com/sites/patrickwwatson/2016/12/01/indias-demonetization-could-be-the-first-cash-domino-to-fall/#54d0783113bb
http://www.livemint.com/Opinion/3iRsq50jHEJI684SMYJ2PI/Demonetisation-without-replacement.html
http://www.stanforddaily.com/2016/12/02/indias-demonetization-and-the-future-2/
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