Money & Finance

Demonetisation: A thunderbolt in search of a target

  • Blog Post Date23 December, 2016
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Ajit Karnik

Middlesex University, Dubai

a.karnik@mdx.ac.ae

In this article, Ajit Karnik, Professor of Economics at Middlesex University, Dubai, examines the various rationales that have been trotted out to justify demonetisation and finds little evidence to back these up. In his view, this seems to have been done mainly because a dramatic gesture was required to keep the supporters of the current government enthused.

The pros and cons of sudden demonetisation that was sprung on the country by Prime Minister Modi on 8 November 2016 have been discussed threadbare. Economists of impeccable reputation have commented on it and have warned that the move is likely to hurt the economy in the short run (Basu 2016, Gopinath 2016, Rogoff 2016). Even Arvind Panagariya, Vice-Chairman, NITI Aayog (National Institution for Transforming India; formerly the Planning Commission) has acknowledged that there will be short-term costs and that the process of demonetisation has been poorly managed (Press Trust of India, 2016). To be fair, there are others (Bibek Debroy quoted in Chakraborty (2016), Bhalla 2016) who have supported the move by the government. 

Searching for a rationale of demonetisation

Curbing black money

During the course of the last month, the objectives of the demonetisation drive have been changing continuously. The initial focus was on curbing black money. However, it soon became apparent that this was unlikely to reveal a large amount of black money since only about 6% of such money is kept in cash. Moreover, the generation or flow of black money has remained unchecked and all that demonetisation could, optimistically, hope to achieve was extinguish only a small fraction of the huge accumulated stock of black money. Consequently, it is not at all surprising that suspicious amounts of money in the form of new currency notes has been recovered during tax raids (Upadhyay 2016).

The above criticism of demonetisation is reinforced by a recent statement of the Revenue Secretary in the Ministry of Finance who has stated that the government expects all scrapped Rs. 500 and Rs. 1,000 notes to come back to the banking system, which then raises questions about the very purpose of the hugely disruptive demonetisation exercise (Indo-Asian News Service (IANS), 2016). It may be remembered that the government expected that, of the Rs. 15.4 trillion of scrapped money, 30% or Rs. 4.5 trillion was black (that is, this money would not find its way back to the banks). It is now being accepted that at most 10% of the Rs. 15.4 trillion may be black money. 

Cashless economy

As the hollowness of demonetisation as a means of controlling black money has become apparent, the vision of a cashless economy has been dangled in front of the country. The Prime Minister has exhorted rural audiences in his election rallies in the Punjab to think of their mobile phones as banks given the difficulty of accessing banks in rural India. While access to banks has increased with the Jan Dhan1 accounts opened during the last two years, the percentage of persons in rural areas without bank accounts is still significant (Reserve Bank of India (RBI), 2016). Moreover, many of the Jan Dhan accounts have a zero balance which suggests that the size of unbanked population may be declining but the numbers of those actually using banks continues to remain low. A cashless society is a chimera which does little to alter the depressing reality where mere access to banks is still a challenge, leave alone usage of mobile banking and plastic money. Before one talks of cashless society, it is important to ensure the spread of banking which, if pursued relentlessly, is likely to meet with much greater success in curbing black money. One cannot leapfrog into cashless society from one which still conducts 68% of its transactions in cash. Forcing people to do so requires coercion and does not sit well with democracy.

Long-term benefits

As the demonetisation story has unraveled and there seems to be no sign of any immediate benefit, there has been talk about the long-term benefits of the move. Finance Minister Arun Jaitley has claimed that “When you are in a cusp of history and you look at the long-term impact of these steps which are going to be taken, I think India is going to become a society in the long term with a certainly better GDP, cleaner ethics, a cleaner economy”. 

Long-term growth requires consistent, stable and predictable policymaking, which then allows private businesses/producers to plan for the future. A severe disruption to the system, like demonetisation, creates doubts in the minds of producers about the policy regime likely to prevail in the future. The natural reaction of risk-averse producers is to postpone crucial investment decisions awaiting clarity regarding the direction policy is likely to take. Over the last two years, private investment has been sluggish at best and demonetisation is likely to act as one more stumbling block for investment decisions. Anyone familiar with the Solow growth model is aware of the importance of private investment in determining growth in an economy. Hence, any disruption that damages the confidence of private players to invest cannot but lead to a drop in investments and, hence, in growth rates in the future.

It is true that numerous cross-country studies have revealed that economies that are low in corruption have been found to perform better (Campos et al. 2010). However, demonetisation has been seen to be anything but an anti-corruption measure. The Prime Minister’s threat of letting loose tax officials to unearth black wealth will achieve nothing apart from causing immense turmoil in the lives of law-abiding citizens, while those with illegal wealth would have squirreled it away from the reach of tax officials. Controlling corruption requires changing the incentive structure for generating illegal incomes. This can happen only when bureaucratic controls are loosened, tax administration is simplified, and ease of doing business is improved. None of the measures on display so far will have the slightest impact on corruption and, hence, no beneficial impact on India’s growth.

Summing up

Having examined the various possible rationales that have been trotted out to justify the demonetisation unleashed by the Prime Minister and found little evidence to back these up, the question remains as to why this step was taken at all? How could a politician, as astute as Narendra Modi, have taken such a momentous step without weighing up the costs of this decision and the damage this might do his and his party’s popularity? I am not in slightest suggesting that the hold of the NDA (National Democratic Alliance) on political power is about to be threatened. With the opposition so completely fragmented and the Congress in thrall of an inept leader-in-waiting, there is little danger of any meaningful challenge to the NDA. However, as the months have rolled on and half the term of the government has been completed, there have been no eyeball-grabbing achievements that the BJP (Bharatiya Janata Party) can boast of to keep its supporters enthusiastic and galvanised for the 2019 elections. Hence, something dramatic was required. The mundane task of governance was clearly not enough to keep intact the popularity of the leader. For example, the perfectly admirable task of improving the ease of doing business in India was taking too long to show dramatic results and hardly made for histrionics at public meetings. India’s position in the World Bank’s Ease of Doing Business has certainly improved since 2014 but it continues to languish at a rank of 130 among 190 nations (World Bank, 2017). Possibly, realising that the hard grind of governing a country was not enough to enthuse the committed supporters of Modi, a dramatic gesture was needed. And, certainly, in the days that immediately followed the announcement of demonetisation, whoops of joy and enthusiasm filled the air. The question is will the euphoria at the discomfiture of those with black money that was initially experienced, by the poor and the middle class continue despite the immense hardship and imperiled livelihoods?

Note:

  1. Pradhan Mantri Jan dhan Yojana (PMJDY) is the Indian government’s flagship financial inclusion scheme. It envisages universal access to banking facilities with at least one basic banking account for every household; financial literacy, access to credit insurance and pension facility.

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